Croatia
Recent Economic Developments

This paper reviews economic developments in the Republic of Croatia during 1990–95. Real gross domestic product fell by a cumulative 30 percent over 1991–93. However, the economy began to recover in 1994 and real GDP grew by 0.8 percent. In the first quarter of 1995, real GDP was nearly 1 percent higher than the corresponding quarter in 1994. The primary impetus to growth in 1994 was from tourism, trade, transport, and communication. Tourism grew by 15 percent in 1994.

Abstract

This paper reviews economic developments in the Republic of Croatia during 1990–95. Real gross domestic product fell by a cumulative 30 percent over 1991–93. However, the economy began to recover in 1994 and real GDP grew by 0.8 percent. In the first quarter of 1995, real GDP was nearly 1 percent higher than the corresponding quarter in 1994. The primary impetus to growth in 1994 was from tourism, trade, transport, and communication. Tourism grew by 15 percent in 1994.

I. Introduction

Croatia began the transition to a market economy with high and rising rates of inflation, economic disruption due to the breakup of the former Socialist Federal Republic of Yugoslavia (SFRY) and the damage caused by war and the unsettled regional security situation. In spite of these difficulties, Croatia has made enormous progress in macroeconomic stabilization. There has been some progress on structural aspects of transformation as well, although much more remains to be done.

The stabilization of the economy was done in several stages but the most significant step was the program launched in October 1993 that almost instantaneously reduced inflation from approximately 2,000 percent at an annual rate to a rate at or below that of the major industrial countries with apparently only a minor adverse impact on output. This reduction in inflation has been maintained for twenty months so far and shows evidence of being sustainable. However, in spite of the success with macroeconomic stabilization, Croatia is still faced with the tasks of restructuring and rebuilding its economic and financial system. Moreover, privatization is incomplete, with the most troubled enterprises still remaining under state ownership.

II. The Real Sector

1. Overview

Following the break-up of the former SFRY and the transition to a market economy, real gross domestic product fell by a cumulative 30 percent over the period 1991-93 (Table 1-3). However, the economy began to recover in 1994 and real GDP grew by 0.8 percent. In the first quarter of 1995, real GDP was nearly one percent higher than the corresponding quarter in 1994 (Chart 1). Anecdotal evidence suggests that the emerging private sector is growing rapidly and is estimated to be nearly half the size of the current and formerly state-owned enterprises. However, the coverage of this sector in the GDP estimates is very weak, leading to a growing bias in the national accounts statistics. Hence, the GDP estimates have to be treated with caution as they may in fact understate growth in the economy.

2. Developments in output and expenditure

a. Sectoral trends

The primary impetus to growth in 1994 was from tourism, trade, transport and communication. Tourism grew by 15 percent in 1994 (Table 3) and the number of overnight stays by foreign tourists increased by 60 percent (Table 10). The recovery in tourism was confined mainly to Istria and islands off the coast as tourists continued to avoid Dalmatia due to the security situation in the region. Consequently, value-added in tourism is still well below the 1990 levels in real terms. There was a large increase in the number of new enterprises in 1994, particularly in restaurants and tourism which increased by 38 percent, and trade which increased by 45 percent. The number of enterprises in the tourism and trade sectors continued to grow in the first quarter of 1995 by 6 percent and 9 percent, respectively (Table 30).

Although aggregate industry and mining output fell by 2.5 percent for 1994 as a whole (Table 3), the seasonally adjusted industrial production index shows a marginal recovery that began in the second half of the year (Table 7). Much of the recovery was due to growth in oil refining and extraction, capital goods and machine building sectors. The recovery appears to be continuing as industrial production in the first quarter of 1995 was about 5 percent higher than the first quarter of 1994. Productivity in industry and mining overall increased by almost 3 percent in 1994 (Table 8).

Agriculture output was stagnant in 1994 (Table 9). Production is organized around companies and cooperatives and small family holdings, and output from agricultural cooperatives declined sharply in 1994. Although production from private farms in both livestock and field crops increased marginally, it was insufficient to offset the decline in output.

b. Income and expenditure

An analysis of GDP by its expenditure components shows that real aggregate domestic demand grew strongly in the second half of 1994. However, the analysis has to be treated with caution owing to the lack of reliable data. The staff estimates presented in Table 6 show that both government consumption and investment expenditure increased sharply in 1994 due to outlays for defense and expenditures on refugees and displaced persons. Although, government consumption increased in 1994, much of the growth in domestic demand in the latter part of the year was due to a surge in private demand, which appears to have been the major force behind the economic recovery. Growth in private demand was driven by a rising real wage bill in the enterprise sector which increased by nearly 40 percent in 1994. Consequently, real aggregate domestic demand grew by over 13 percent in the second half of 1994. The growth in domestic private demand contributed to substantial domestic capacity coming into production and a spillover into imports.

3. Employment, wages, and the labor market

a. Employment

Employment data in Croatia, based on employment surveys conducted by the Central Bureau of Statistics which cover mainly the formerly socially-owned enterprises, are no longer representative of total employment in the economy. In 1990, almost 95 percent of employment was in the socialized sector. Although, private sector employment has increased in recent years, the series does not cover the emerging private sector and, therefore, understates total employment in the economy. Employment data based on workers paying pension contributions are a more accurate representation of total employment even though its coverage of the new private sector is not comprehensive. Table 13 presents the revised series from 1991 onwards. The private sector includes farmers, entrepreneurs, independent professional workers as well as private enterprises. Although private sector employment has been increasing steadily from 1991, the data show a sharp increase in 1994 due to a reclassification to include enterprises established in the process of privatization. Employment in the majority state-owned enterprises and the public sector (which includes the defense forces) shows a steady decline, in part, as workers move to the private sector. Table 14 provides a breakdown of employment across different sectors of the economy. Recorded employment fell by 5 percent in mining and industry, 6 percent in transport and communication, and nearly 10 percent in trade.

Chart 1
Chart 1

Croatia: Real GDP, 1989-95

(Millions of constant 1990 kunas)

Citation: IMF Staff Country Reports 1995, 131; 10.5089/9781451817225.002.A001

Source: National Bank of Croatia and staff calculations.

Registered unemployment figures, which nearly doubled to about 300,000 in 1990-91, have declined to about 240,000 in the first quarter of 1995 due to several factors (Table 13). The decline is attributed to out-migration to Western Europe, some recovery of economic activity as well as active policy measures initiated by the Employment Agency in 1993. Despite high levels of unemployment, there is a shortage of skilled labor to meet the demands of the employers, caused in part by extremely low wages leading to emigration, as well as by the lack of special skills. The Employment Agency has allocated approximately 30 percent of its budget for measures to promote employment. Nearly 28,000 people are currently covered by the measures, which focus on incentives for employers to hire certain categories of the unemployed, labor retraining and assistance for self-employment. The measures include financial support for employers who hire trainees or workers with recent university and high school degrees. The Agency also provides training programs for the unemployed in building activities, textiles, administrative and secretarial skills as well as cofinancing training programs for workers in existing jobs. To encourage self-employment, it provides initial financing assistance for trade and other activities. In addition, to encourage labor mobility to regions with labor shortages, the Agency provides financial assistance to cover the costs of moving and housing.

An Employment Act is expected to be submitted to Parliament in September with additional measures to encourage job mobility and labor retraining. These will include cofinancing programs for acquiring special skills, retraining programs for younger people, as well as professional rehabilitation programs. The Act will also focus on measures to encourage individuals to work at home, to financially support employers to employ older people and to adapt the work place for the physically handicapped. In addition, under the proposed Employment Act, unemployment benefits would be greatest at the start and decline over time in order to create incentives for the unemployed to find new jobs. Under the present system, unemployment benefits range from 3-18 months. The unemployment benefit is 50 percent of the salary in the last three months. To be eligible, an individual should have worked for 9 consecutive months or for a period of 12 months with interruptions during the preceding 18 months.

b. Wages

The aggregate annual real wage bill (which includes both wage and nonwage compensation) rose by nearly 40 percent in 1994 (Table 15) due primarily to wage growth in the private sector. 1/ The growth in private sector wages appears to be driven by productivity increases and by the demand for skilled labor. Despite the increase, the real wage bill is still substantially lower than its 1990 level. In early 1995, there was a shift from nonwage compensation to wage compensation which distorts the series on wages. Total seasonally adjusted income grew by 8.5 percent from December 1994 to April 1995.

Under the stabilization program, the majority state-owned enterprises and the public sector are subject to wage controls and overall wage increases in these sectors have been in keeping with the guidelines. 2/ In addition, no wage increases can occur in loss-making enterprises. Although the wage control mechanisms for these sectors appear to be operating satisfactorily (see table below), it has been difficult to assess whether wage growth has been in line with the stipulated increases. The problem is due, in part, to the way in which the data are collected. From January 1995, all allowances (such as meal, transportation and vacation allowances) are included in the information which enterprises are required to report to the payments authority, ZAP. Therefore, in order to make the appropriate comparisons between 1994 and 1995, wage payments in October 1994 need to be adjusted for these allowances. Under the existing self-reporting system, enterprises report the maximum salary payable and the actual payments made to the payments authority. At present, verification is not automatic, although the data are subject to review by the Government.

Salaries in Majority State-Owned Enterprises, Banks, and Other Financial Institutions

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Source: Payments authority (ZAP).

c. Labor market

The major development in the area of labor market policies was a Labor Law passed by Parliament in May 1995. The new law which goes into effect from January 1, 1996 is a significant improvement over the old law as it introduces a legal framework under which employers can lay off workers. In addition, the law introduces contractual employment allowing employers to establish the terms and conditions of work while it also establishes freedom of association for labor and gives precedence to collective bargaining agreements. Workers can be represented by freely elected labor councils or trade unions. The law allows for minimum wage determination at the level of either the firm or the industry through the collective bargaining process. These aspects of the Law are elaborated in greater detail below.

Under the new Labor Law, an employment contract may be terminated if a company is having problems, if the employee’s skills or qualifications do not match the job requirements, or if the employee cannot fulfill his or her contractual obligations. It also distinguishes between small firms (employing up to 5 workers) and larger firms (with more than 25 workers). Smaller firms face fewer constraints in firing workers, while larger firms that intend to lay off more than 60 percent of their labor force have to find jobs for these workers in other companies and provide a rationale for their action.

The Law also regulates the amount of severance pay to which a worker is entitled. If he/she has been employed continuously for a period of two years, the minimum severance pay is equivalent to half the average monthly wage of that employee. In addition, an employee is entitled to a minimum notice period of 2 weeks, which can increase to 6 months for workers that have been employed for over 20 years. Before giving notice, the law requires the employer to consult with the Labor Council and find the worker an alternative job.

Although trade unions have been granted the right to strike, the law sets certain minimum standards relating to its announcement, the motivation for the strike as well as the arbitration process. Employers have the right to initiate a lock-out, (up to 50 percent of their employees) but only after the strike has begun and the arbitration process has failed to resolve the dispute in the stipulated time.

4. Price Developments

The stabilization program initiated by the Croatian authorities in October 1993 has been extremely successful in containing inflation. It focused on measures to break ingrained inflationary expectations, and improve financial disciple among the enterprises. Inflation is now at or below industry country levels. Prior to the stabilization program, most prices were implicitly indexed to the exchange rate against the deutsche mark. With the appreciation of the exchange rate following the stabilization, prices began to decline after a lag and the decline persisted over several months. From December 1993 to December 1994, the consumer price index fell by 3 percent in 1994, while producer prices fell by 5.3 percent. In the first half of 1995, retail prices increased by 1.4 percent, while producer prices fell by a further 0.6 percent (Table 23).

5. Enterprise Sector

a. Privatization and institutional reform

After independence, the Croatian authorities embarked on a program of economic reform, based on privatization of the socially-owned enterprises. The legal framework for privatization was established by the Law on Transformation of Socially-owned enterprises in 1991, which covered all manufacturing and agricultural enterprises and also created the Croatian Privatization Fund (CPF). 1/ Under the law, formerly socially-owned enterprises had to submit a privatization plan (including a restructuring plan) to the CPF by June 1992. Once the privatization plan was approved, shares would be offered to employees at a discount. One third of the unsold shares would be distributed to the Pension Funds and the remaining two thirds to the CPF. The CPF, in turn, would sell the shares in its portfolio through auctions on the Zagreb Stock Exchange, public bids in the newspapers, sales via agents, direct settlements with individual investors and debt-equity swaps. By December 31, 1994 approximately 47 percent of the enterprises approved for privatization had been fully privatized; the Croatian Privatization Fund (CPF) had a minority stake in 37 percent of the enterprises and a majority stake in the remaining 16 percent. In addition to the formerly socially-owned enterprises, there are 10 public enterprises under direct state ownership which include INA (the oil and gas company), the electricity company, the railways, and post and telecommunication. These 10 enterprises accounted for about 10 percent of GDP and 6 percent of the work force in 1994 (Table 29).

Although privatization of smaller enterprises proceeded rapidly, privatization of larger enterprises has encountered a number of problems such as valuation of assets and liabilities and over-staffing problems. The Government now intends to streamline the privatization process for the formerly Socially-Owned Enterprises (FSOEs) held by the CPF and extend it to cover public enterprises. To this end, it established the Ministry of Privatization in November 1994 and put forward a Privatization Law which is expected to be passed by Parliament in October 1995. Public enterprises intended for privatization are required to carry out reorganization plans along business lines and profit/loss centers. These reorganizations are expected to be completed by the end of the first quarter of 1996. The main features of the proposed Privatization Law and an overview of recent developments in the public enterprises with regard to the privatization process are given in Appendix II.

b. Enterprise financial discipline and restructuring

An important component of the Croatian stabilization program has been an attempt by the Government to harden budget constraints for majority state-owned and public enterprises. In 1993, the Office for Restructuring of Public Enterprises (ORESE) was established which monitors the performance of these enterprises based on information on receivables, payables, and cash flows. Increased monitoring by ORESE as well as the introduction of external audits has improved the assessment of their financial performance. In an effort to impose financial discipline on these enterprises, two measures were taken. First, the authorities tried to loosen the nexus between banks and enterprises that have shares in these banks through credit ceilings on lending to related parties. Under the ceilings, banks can extend credit to enterprises holding 10 percent of their equity, but lending cannot exceed 5 percent of their capital. In addition, individual credit limits were established for a group of 19 mostly large, financially troubled enterprises. The ceilings on these selected enterprises have been effective in reducing credit to selected enterprises. Second, no wage increases are permitted in loss making enterprises. ORESE and the payments authority (ZAP) indicate that the firms have complied with this directive.

The tightening of credit to troubled enterprises has led to liquidity problems which have flowed into inter-enterprise arrears. Data on unsettled payments orders from the payments authority provide an indicator of inter-enterprise arrears in the economy. To the extent that all liabilities are not recorded by ZAP, the data understates the extent of arrears. On December 31, 1994, the total amount of unsettled payments orders was HrK 2.9 billion, which rose to HrK 4.8 billion at the end of April, 1995, and is approximately 5 percent of GDP. In March, a decree was introduced requiring majority and fully state-owned enterprises to meet payment obligations by the end of June and to give priority to claims outstanding since December 31, 1994. The decree expired at the end of June and the Government intends to replace it by a law on bankruptcy and liquidation. The oil and gas company (INA), together with Croatian Railways account for a significant share of total arrears. Overdue amounts payable by INA were HrK 1.1 billion, accounting for about 25 percent of total settlement arrears at the end of April 1995. Lending to INA is below the credit ceiling imposed under the program owing to the reluctance of banks to lend. In May 1995, a restructuring program for INA was approved, which if successful, could reduce the deficit sharply. However, the restructuring itself will require substantial injections of capital and a reduction in its labor force.

c. Bank rehabilitation

In addition to imposing financial discipline on the enterprises, the government is also restructuring the banking system. Croatia inherited a decentralized two-tier banking system from the former SFRY in which most commercial banks were owned by their major borrowers. For many of these banks, a large share of their assets consisted of poorly performing loans to related-party enterprises. Furthermore, a large part of the liabilities of banks consisted of household foreign exchange deposits for which the counterpart foreign exchange assets were held at the central bank of the former SFRY. These foreign exchange assets became unavailable at the time of the breakup of the SFRY.

To increase the solvency of the banks, the Government recapitalized the banks in 1991 by issuing bonds in exchange for nonperforming bank claims on enterprises. It also assumed the claims of commercial banks on the central bank of the former SFRY corresponding to household foreign exchange deposits. Since these claims were nontradable, these operations effectively transformed the solvency problem into a liquidity problem. However, over the past three years, the quality of commercial bank portfolios has been improving although liquidity problems remain.

The government has also relied on privatization and new entry to improve the solvency and efficiency of the banking system. In 1995, one of the two largest banks announced that it had transformed itself into majority private ownership. In addition, several new private banks have begun operations and become significant competitors in the banking system. In 1994, the Bank Rehabilitation Agency (BRA) was established to restructure/liquidate large problem banks and enterprises. In early 1995, the BRA took over a major regional bank, Slavonska Banka, leading to a capital injection. The initial steps in the takeover of the largest of the problem banks, Privredna Banka, will begin in late 1995.

6. Competitiveness, real wages, and productivity

The real effective exchange rate (REER) based on producer prices appreciated by 28 percent from December 1992 to December 1994. Much of the appreciation that occurred in 1993 was in the last quarter of the year, immediately following the initiation of the stabilization program. From December 1993 to December 1994, the REER was relatively stable (Chart 2). Given the size of the appreciation which has occurred, there have been concerns about whether it has adversely affected the competitiveness of the Croatian economy. Although the extent of appreciation would suggest that this may be the case, several factors make it difficult to establish a clear answer to this question. For example, it is difficult to assess the equilibrium level of the real effective exchange rate, as the Croatian economy has faced significant shocks resulting from the war and the transition. Chart 2 shows the current account balance for Croatia, excluding private and official transfers. The data have to be treated with caution due to breaks in the series resulting from the dissolution of the SFRY in 1991 and re-classification of export processing activities in 1990. 1/ Given these caveats, the data show that historically, Croatia has had a surplus on its current account, due mainly to tourism which accounted for about 70 percent of the net income on the services account. The surplus on the services account plummeted in 1991, following the outbreak of the war. There has been some recovery since, but tourism is still adversely affected by the security situation. Hence, developments in the services account may not be predominantly related to changes in the real exchange rate. Likewise, changes in the trade balance during 1990-92 are probably related to the conflict surrounding the dissolution of the SFRY. Nonetheless, the merchandise trade deficit did widen in 1993 and 1994 as the real exchange rate was appreciating.

This brief graphical examination of current account trends would appear to suggest that the real exchange rate appreciation may have contributed to the recent deterioration in the trade account. However, it also seems to indicate that the initial REER–inherited from the SFRY–was undervalued from the point of view of Croatia given the large current account surpluses. In addition, a study by Anušić et al (1995), indicates that changes in the real exchange rate do not have a significant impact on exports or imports. 2/ Anušić et al find the income of OECD countries to be the major explanatory variable in the export equation and domestic income in the import equation. It would appear that while the appreciation of the exchange rate has contributed to a widening of the trade deficit, there is little evidence that the export sector has become uncompetitive, especially in view of the sharp increases in exports which took place in 1994 and early 1995. 1/

It would also be useful to look at changes in the REER based on unit labor costs. However, historical monthly sectoral data on wages and productivity for Croatia are not available. Data on average real wages in the economy show a sharp decline since 1992 and by a far greater proportion than productivity. 2/ In 1994, real wages increased by about 30 percent and outstripped productivity gains which were about 3 percent. Despite the increase, however, real wages are still well below productivity and substantially below their 1990 levels. It could be argued that real wage movements are mostly catching up to those of productivity.

International comparisons of the average wage expressed in U.S. dollars can also provide an indicator of changes in competitiveness. Although such comparisons need to be interpreted with caution, the data show that the dollar wage in Croatia declined from $415 in 1991 to $140 in 1993 and then rose to $234 in 1994. This is higher than the level in the Former Yugoslav Republic of Macedonia at the end of 1994 ($175), close to the average wage for the Czech Republic ($240) in 1994, but considerably lower than Slovenia which was $467. The wage in Croatia is now close to the average for the period 1987-1989 of $249.

In sum, the evidence appears to be mixed. While the REER appreciated in 1993 relative to its earlier level, it appears to have stabilized in 1994. Although the appreciation has been accompanied by a widening of the trade deficit, exports grew by 9 percent in 1994 and are expected to grow by 15 percent in 1995. Meanwhile, real wages have fallen by much more than productivity, and are still substantially lower than their level in the late eighties. Overall, these factors suggest that the appreciation may have had a limited adverse effect on the competitiveness of the Croatian economy.

Chart 2.
Chart 2.

Croatia: Competitiveness, Real Wages, and Productivity 1987-94

(Millions of constant 1990 kunas)

Citation: IMF Staff Country Reports 1995, 131; 10.5089/9781451817225.002.A001

Source: National Bank of Croatia and staff calculations.1/ Series break from January 1992.

III. The Public Sector

1. Structure of the public sector

Since independence, the structure of the public sector has been gradually rationalized and streamlined, and as of mid-1995, the general government consisted of the budgetary central government; five extrabudgetary funds; and the local authorities, comprising 20 counties, 78 cities, and 426 municipalities. The budgetary central government is the largest spending unit, with expenditures mainly concentrated in goods and services, while its revenues arise primarily from taxes on the sale of goods and services, imports, income and profits. Revenues of the extrabudgetary funds consist of payroll contributions and transfers from the budgetary central government, while most of their expenditures cover social security transfers to households with smaller amounts of expenditures on goods and services. Local authorities receive their revenues from taxes levied on income, property, and gambling, and from transfers from the central budget, while their expenditures complement budgetary central government’s expenditures.

At independence, the Croatian government had a highly decentralized institutional framework to collect revenue, control expenditures, and manage financial flows. Since then, tax collection has been consolidated and coordinated under the general oversight of the Ministry of Finance, and further efforts to consolidate tax revenues are underway as the government plans to introduce a value-added tax in 1997 and to rationalize import taxes in the course of 1996. An organic budget law passed in December 1994 provides for the coordination of the government’s fiscal policy by defining the processes for budget preparation and execution, the establishment of a comprehensive treasury system, and external audits. This framework will be implemented over the next few years.

Before independence, education, health service, and social security were provided primarily by highly decentralized, independent entities, referred to as “self-governing communities of interest.” However, shortly before independence, control of these public services was centralized in funds and disciplined by laws regulating their revenues and expenditures. As of January 1, 1995, there were four social funds (the Pension Fund, the Health Fund, the Employment Fund, and the Child Benefit Fund) plus the Water Management Fund. 1/ Revenues of the extrabudgetary funds derive mainly from payroll taxes and government transfers, 2/ while the entitlements of their clients are set by law. The extrabudgetary funds operate under the general oversight of the Ministry of Finance, although the extrabudgetary funds continue to have a high degree of independence in their operations.

There are 20 counties and 78 cities and 426 municipalities within the counties. 1/ Local governments receive most of their receipts as revenue sharing from national taxes. Counties receive 5 percent and 10 percent of revenues from national income and profit taxes, respectively; cities and municipalities receive 25 percent, 50 percent, and 60 percent of revenues from income, gambling and property taxes. Cities with more than 40,000 inhabitants can levy a surcharge of up to 30 percent (up to 60 percent for Zagreb) on income taxes. Counties may also levy taxes on vehicles, boats, the organization of public events, and inheritance. Cities and municipalities may levy limited taxes on the sale of beverages consumed in restaurants, weekend houses, and advertising. The central government budget also transfers money to counties with per capita income below 75 percent of the average, and counties transfer resources to their poorer municipalities. Local authorities’ expenditures are mainly concentrated in housing and community development, local water supply and water transportation, environmental protection, cultural and sports activities, services for agriculture, forestry, fishing, tourism, local roads, and pre-primary and primary education.

Employment in the budgetary central government, extrabudgetary funds and local authorities was 52,298 persons by the end of 1994, equivalent to about 2.8 percent of the estimated labor force. Total government employment, including employment in health care, social services, and education was 234,954 persons, a level that is equivalent to 12.4 percent of the total labor force (Table 32).

2. Recent developments in the budgetary central government

a. Overview

The overall cash balance of the central government budget for 1994 is estimated at a surplus of 0.6 percent of GDP compared to a surplus of 0.2 percent of GDP in 1993. However, part of interest payments due on the counterpart of the frozen foreign exchange deposits in mid-1994 were rescheduled to the first quarter of 1995, reducing the overall 1994 surplus on an accrual basis to 0.4 percent of GDP. The budgetary central government had a cash surplus running at an annual rate of about 0.6 percent of GDP in the first quarter of 1995. The surplus on an accruals basis was also running at an annual rate of 0.7 percent of GDP. Although interest on the counterpart to the frozen foreign exchange deposits that was accrued prior to 1995 but rescheduled into 1995 was paid during the first quarter, an approximately equal amount of interest coming due in 1995 was in arrears at end-March 1995. In April 1995, these arrears were regularized by the issuance of promissory notes and cash payments, and by May 1995 the budgetary central government had a deficit of less than 0.1 percent of GDP on a cash basis and a surplus of 0.2 percent of GDP on an accrual basis. 1/

b. Revenue 2/

In 1994, total revenues of the budgetary central government, including the Road Fund, were equal to 28.9 percent of GDP (Table 33). In the first five months of 1995, revenues were running at an annual rate of 30.8 percent of GDP. Revenues from taxes on goods and services 3/ amounted to 18.9 percent and 19.7 percent of GDP in 1994, and the first five months of 1995, respectively. In 1994, tax revenues from goods and services increased significantly relative to 1993 in large part because of improved tax collection due to an increase in the number of tax inspectors and an increased effort to collect taxes from the emerging private sector. In the first five months of 1995, tax revenues increased because of strong growth in the underlying tax base. In 1994 and the first five months of 1995, revenues from import taxes amounted to 4.1 percent and 4.5 percent of GDP, respectively, compared to only 2.7 percent of GDP in 1993, an increase which reflects higher imports and improved tax administration.

Revenue from income and profit taxes increased from 2.2 percent of GDP in 1993 to 4.5 percent of GDP in 1994 and 5.2 percent of GDP at an annual rate in the first five months of 1995. These favorable developments were primarily the result of further simplification of income and profit taxes, improved tax compliance, and strong real wage growth. A new income tax law, which went into effect on January 1, 1994, simplified the income tax system by introducing a system with an exemption up to HrK 700 per month, a 25 percent rate on taxable income up to three times the minimum wage, and a 35 percent rate on income above three times the minimum wage. 4/ A new profit tax act, which also went into effect on January 1, 1994, instituted a 25 percent tax on profits of residents and nonresidents operating a business in Croatia. The tax base is reduced by an amount equal to a return on equity of 3 percent adjusted for the rise in the producer price index.

Capital revenues, including privatization receipts, were only 0.4 percent of GDP in 1994 and 0.3 percent of GDP in the first five months of 1995, compared to 0.4 percent and 0.2 percent in 1992 and 1993, respectively. This low outturn was due mainly to the absence of an adequate institutional framework to mobilize domestic and foreign savings for privatization, and the greater than anticipated restructuring needs of the remaining state-owned enterprises.

c. Expenditures

In 1994 total expenditures of the budgetary central government 1/ amounted to 28.2 percent of GDP on a cash basis (Table 34). About 9.4 percent of GDP was spent on wages and salaries, including employer contributions, compared to 5.8 percent of GDP in 1993. This increase reflects mainly the reclassification of about 30,000 employees from the payroll of local authorities and the Road Fund to the budgetary central government, and modifications to the wage structure of civil servants that resulted in a significant increase in wages effective from October 1994. 2/ In the first five months of 1995 expenditures on wages and salaries were running at an annual rate equivalent to 12.4 percent of GDP, reflecting, in addition to the November increase, a wage increase of 22 percent for professional soldiers on January 1, 1995, which was retroactive to October 1994.

Interest payments on a cash basis were equivalent to about 1.2 percent of GDP in 1994, compared to 0.5 percent of GDP in 1993. However, by mid-1994 interest payments due on the counterpart of the frozen foreign exchange deposits were rescheduled into the first quarter of 1995. 3/ On an accrual basis, interest expenditures in 1994 were higher by 0.2 percent of GDP. Although the amounts rescheduled from 1994 were repaid in the first quarter of 1995, only 30 percent of interest payments coming due at the beginning of 1995 were paid by end-March 1995. Additional cash payments were made in April 1995 and the remaining 57 percent was rescheduled by the issue of promissory notes. 4/

Subsidies and other current transfers were equivalent to 3.3 percent of GDP in 1994, compared to 3.4 percent of GDP in 1993. In 1994 the agriculture sector and railways received about 56 percent of total subsidies. Subsidies to agricultural fell from 0.8 percent of GDP in 1993 to 0.5 percent of GDP in 1994, while subsidies to railways increased from 1.0 percent of GDP in 1993 to about 1.3 percent of GDP in 1994, reflecting the slow progress in the restructuring of this sector and the need to reconstruct infrastructure affected by the war. During the first five months of 1995, subsidies and other current transfers were equivalent to 3.5 percent of GDP at an annual rate. Subsidies to rehabilitate the railways are expected to increase in order to reopen railroad service through areas of Croatia recently brought back under Government control.

Capital expenditures and net lending were equivalent to 3.0 percent of GDP in 1994 and 2.1 percent of GDP at an annual rate in early 1995. Capital expenditures slowed in early 1995 because of new procedures for spending, agencies requiring detailed expenditure plans and the integration of the Road Fund into the budget. The legal changes associated with the integration of the Road Fund into the budget slowed disbursements by international financial institutions related to highway projects. The operations of the Road Fund have since been regularized, and it is expected that parliament will pass the necessary permanent legislation by September 1995.

Data on expenditures by function (Table 35) show that in 1994, 9.1 percent of GDP was spent on defense (34.3 percent of total budgetary expenditures) compared to 7.8 percent of GDP in 1993. About 56 percent of total defense spending was concentrated in wages and salaries. Expenditures on education were equal to 3.4 percent of GDP in 1994, up from 2.0 percent in 1993, partly reflecting higher wages for teachers.

In 1994, budgetary expenditures on social welfare 1/ were equal to 3.0 percent of GDP, compared to 2.0 percent of GDP in 1993. A substantial part of this expenditure is concentrated in the Social Program which was established in 1993 to assist those affected by the war and the transition to a market economy through the transfer of in-kind benefits and subsidies for food, clothes, utilities, and rent. 2/ The cost of this program was 0.8 percent and 1.0 percent of GDP in 1993 and 1994, respectively, as is shown in the Tables below.

Social Program Expenditures

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Source: Ministry of Labor and Social Welfare, and staff calculations.

Social Program Monthly Benefits

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Source: Ministry of Labor and Social Welfare, and staff calculations.

Spending on refugees and displaced persons amounted to 1.7 percent of GDP in 1994 and 1.5 percent of GDP (at an annual rate) in the first three months of 1995, compared to 2.1 percent of GDP in 1993. These expenditures assisted 516,283 and 370,625 persons in 1993 and 1994 (approximately 11 percent and 8 percent of Croatia’s population), respectively. About 0.8 percent of GDP was used for the reconstruction of infrastructure damaged by the war in 1994, compared to 0.9 percent in 1993 (see Table below).

Expenditures on Reconstruction

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Source: State Institute for Macroeconomic Analysis and Forecasting, and staff calculations.

d. Financing

In 1994 and early 1995, budgetary financing was dominated by a buildup of banking system deposits. Although difficulties in monitoring complicate the measurement of deposits under the control of the spending agencies, it is clear that the bulk of the 1994 cash surplus of HrK 544 million was deposited in the domestic banking system. The government repaid HrK 203 million of its debt to the National Bank of Croatia (NBC) in 1994 and a further HrK 55 million in the first five months of 1995. External financing was modest as repayments of external loans in 1994 and the first five months of 1995 were almost as large as new disbursements. In 1994, the budgetary central government, including the Road Fund, obtained HrK 47 million in external financing and it repaid HrK 95 million on external loans. Disbursement and amortization of external loans were HrK 88 million and HrK 15 million respectively in the first five months of 1995. In its domestic non-bank financing during 1994, the Government issued HrK 160 million (0.2 percent of GDP) in new Reconstruction Bonds 1/ and repaid HrK 70 million on a “depreciation loan” raised from enterprises earlier in the 1990s. There was no issuance or amortization of domestic non-bank debt in the first five months of 1995.

3. Extrabudgetary funds: developments and prospects

Total expenditures of the extrabudgetary funds were equivalent to 19.7 percent of GDP in 1994. A significant part of these outlays consist of transfers to households financed on a pay-as-you-go basis. Total revenues of the extrabudgetary funds were equal to 20.7 percent of GDP in 1994. The Pension and Health Funds accounted for 48 percent and 34 percent, respectively, of both total revenues and expenditures of the extrabudgetary funds. Revenues accrue mainly from earmarked payroll taxes and transfers from the central budget. The Pension Fund also obtains revenue from its portfolio of shares in enterprises. The social funds are required to balance their budgets, and in 1994 the extrabudgetary funds had a combined surplus equivalent to about 1 percent of GDP.

The Pension Fund consists of three funds; the Workers Fund, the Fund of the Self-Employed and the Farmers Insurance Fund. In 1994, these funds provided retirement pensions, disability pensions and survivor pensions to about 813,382 persons (Table 22). The Pension Fund had a small surplus equal to 0.4 percent of GDP in 1994, as its total revenues amounted to 9.9 percent of GDP, while its expenditures were equal to 9.5 percent of GDP. About 96.5 percent of the revenues of the Pension Fund were derived from payroll contributions by employers, employees, self-employed and farmers while about 3.5 percent of total revenues accrued from its portfolio of shares in enterprises. About 95.2 percent of its total expenditures were transfers to households and non-profit institutions.

Pensions are determined on the basis of the ten highest consecutive years of earnings, corrected for inflation. There is also a guaranteed minimum pension provided that neither the retirees nor members of their households have other sources of income sufficient to support them. In 1994, 91,251 retirees (11 percent of the total), whose pensions were below the minimum were entitled to a compensatory supplement. In 1993, the average retirement age for old age retirees was 57 and 53 years for men and women, respectively, while the average age for disability pensioners was 50 and 46 years for men and women, respectively. These disability pensioners represented about 23 percent of the total number of pensioners in 1994. The total number of pensioners rose from 548,586 persons in 1988 to 784,364 persons in 1994, a 43 percent increase (Table 22), reflecting mainly the early retirement of redundant labor as other forms of labor shedding were severely hampered by the existing labor laws.

Pension Fund

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Source: Pension Fund.

In order to make the pension system more secure and promote economic growth through higher savings, the Croatian authorities are planning to switch in the medium term to a multi-pillar system under which mandatory savings would be complemented by obligatory funded individual accounts. 1/ An interim revision of the existing pension law is under preparation and is expected to be enacted by late 1996. The main elements of the new proposed draft law are an increase in the retirement age for men and women from 60 to 65 years, and from 55 to 60 years, respectively; a tightening of the link between the entitlement and life-time contributions; 2/ indexation of pensions to the consumer price index, rather than wages; and the abolition of special retirement regimes. Apart from the start-up cost of new institutions, there are significant financial costs which arise from the initial capitalization of the second pillar. The economically active population has to provide for the pensions of the already retired, while at the same time they also have to start to save in their own individual retirement accounts. Indirect benefits of the multi-pillar system with mandatory individual retirement accounts include the promotion of financial markets which should help to accelerate the pace of privatization.

At independence, Croatia inherited a very decentralized medical care system with few built-in incentives for cost control; few preventive care programs existed and primary care was primarily restricted to referral services and elementary prescription. In addition, with the outbreak of hostilities in the region there was an increased demand for health services as a result of war injuries and the inflow of displaced persons. In order to control costs and improve health services, Parliament passed the Health Care Law and the Health Insurance Law in August 1993, defining the management structure for all health institutes, regulating private practice, improving the collection of contributions, and allowing for voluntary insurance schemes (Table 20). In 1994, the Health Fund had a surplus of 0.4 percent of GDP as revenues were equal to 7.1 percent of GDP and expenditures equal to 6.7 percent of GDP. About 93.5 percent of the revenues of the Health Fund came from payroll contributions by employers and employees, while 83.8 percent of its expenditures covered outlays on goods and services and 11.6 percent consisted of direct transfers to households.

The Employment Fund provides unemployment benefits and manages job placement programs. The activities of the Employment Fund are primarily financed by a 1.9 percent contribution rate on payrolls. About 40 percent of its resources are allocated to job placement programs, including wage subsidy schemes, while the rest is spent on unemployment benefits, and the medical insurance and pensions of the unemployed. The duration of benefits depends on the willingness to work and seniority, while the level of the benefits is based on past earnings. In 1994, the Employment Fund had a small surplus of 0.1 percent of GDP, as total expenditures of the Employment Fund amounted to 0.6 percent of GDP, while its revenues were equal to 0.7 percent of GDP. In the first four months of 1995 there was a surplus equivalent to 1.4 percent of GDP at an annual rate. Future developments in the financial position of the Employment Fund are closely related to the unemployment effects of privatization and enterprise restructuring, the evolution of real wages and contribution rates, and the extent to which the Employment Fund redefines its role from a provider of unemployment benefits and job placement programs, to an agency which solely provides unemployment benefits.

Child welfare is regulated by the Law on Family Allowances for Children of 1977. Child allowances are granted to children up to the age of 15, and after that age during the period of regular schooling, as well as to children that are physically or mentally impaired. Child benefit entitlements are conditional upon the period of insurance of the claimant, and the income of the household. In 1994, 204, 975 claimants, with 378, 434 dependent children, received an average child benefit of HrK 170 (US$28) per month (Table 21). In 1994, the Child Benefit Fund had a surplus of less than 0.1 percent of GDP, as total expenditures of the Child Benefit Fund amounted to 0.8 percent of GDP, covering primarily transfers to households, while its revenues were equal to 0.8 percent of GDP, stemming primarily from a 2.5 percent payroll contribution by employees.

The Water Management Fund plans, constructs, and maintains the national infrastructure for water supply and water transportation. In 1994, it had a deficit as its revenues and expenditures were equal to 0.5 percent and 0.6 percent of GDP, respectively. Its primary source of revenues arises from payments for water use and a 0.76 percent tax on gross salaries paid by employers. In 1994, the Water Fund received foreign financing of HrK 34 million from an Austrian-German bank consortium, for the construction of water pipelines, with a similar amount disbursed in April 1995.

The Road Fund is responsible for planning, construction, maintenance and rehabilitation of all public interurban roads. In 1994, its revenues amounted to 1.7 percent of GDP, while its expenditures amounted to 1.5 percent of GDP. As of January 1, 1995 the operations of the Road Fund are consolidated in the operations of the budgetary central government. In 1994, there was a net repayment of loans disbursed in the early eighties by international financial institutions for about HrK 95 million.

IV. The Financial Sector

1. Introduction

The dominant monetary development of the last two years has been the implementation of the October 1993 stabilization program. However, in spite of the success of this program, there are significant structural problems in the Croatian financial system remaining. Banking system illiquidity reflects both bank rehabilitation needs and a lack of financial markets and tradable assets that is a problem for even those banks with healthy portfolios. Also related to these structural problems are persistent, wide interest rate spreads, and large amounts of nonperforming and highly illiquid long-term assets (including claims on the government) in bank portfolios.

2. Monetary and interest rate developments

a. The October 1993 stabilization program

Prior to October 1993, Croatia experienced near hyper-inflation. To some extent, this inflation was inherited from the former SFRY; inflation was running at annual rates of approximately 500 percent at the time of monetary independence in December 1991. However, an accommodating monetary policy subsequent to monetary independence contributed to an acceleration of this inflation. By the third quarter of 1993 inflation was running at an annual rate of approximately 2,000 percent.

Inflation persisted even in the absence of significant fiscal or quasi-fiscal deficits because of indexation and backward-looking monetary policies that sustained inflationary shocks. Widespread indexation and currency substitution prevailed throughout the economy. Limits on NBC credit available through refinancing facilities, the interest rate on those facilities, and the rate of depreciation of the exchange rate were all set through a system of backward looking-indexation. Almost all public debt was indexed to either the producer prices or denominated in foreign exchange. At end-September 1993, just under half of broad money and 52 percent of deposit money were denominated in foreign exchange.

The authorities had come to the view that inflation in Croatia had become largely inertial by late 1993 and could be brought down to low levels relatively quickly if indexation could be broken and inflationary expectations changed. By the time that the October 1993 stabilization was announced, the consolidated central government was running a small deficit of approximately 0.8 percent of GDP (Table 36) and the enterprise sector, which had made extensive use of new banking system credit to finance operating deficits and interest payments in 1991 and 1992, had shifted into aggregate operating and financial surpluses. With these trends expected to continue, they felt that there would be little need for significant further increases in the nominal money supply to finance either government or enterprise deficits and that an aggressive monetary stabilization program could be put into place.

The stabilization program announced on October 3, 1993 had several policy components, but it put most of its emphasis on restrictive base money targets (the sum of currency outside banks, vault cash and reserve and giro deposits in Table 38). These base money targets were to be achieved through restrictions on the amount of foreign exchange that the NBC would purchase in auctions from commercial banks each month. These foreign exchange purchases were to be the only source of new base money. In addition to the base money limits, there was a limit on the depreciation of the exchange rate for the remainder of 1993. 1/ These limits were intended to be a floor on the depreciation of the exchange rate rather than a crawling peg. The announced exchange rate policy was a shift to a freely floating exchange rate and the authorities expected to interbank market to clear at rates somewhat more appreciated than these limits. 2/

The inflation targets of the program were 25 percent for October, 15 percent for November, and 9 percent for December. The announced base money growth limits were 17.3 percent for October, 3.5 percent for November, and 3.5 percent for December. 3/ No remonetization was assumed in the program’s projections; the difference between the inflation targets and the base money growth limits implied a cumulative decline in real base money of 20 percent by end-December 1993 (see Table below).

Shortly after the program was launched, unexpected developments in money demand and inflation brought about a change in the character of the program. During October, the base money targets were nearly met. However, higher than expected October inflation resulted in a much greater compression of real base money than that implied by the announced targets. At the same time, holdings of currency outside banks rose by 57 percent as a combination of real transactions demand for currency and positive announcement effects of the program increased currency demand. As a result, the stock of nominal base money available for meeting bank reserve requirements fell sharply and threatened a banking system crisis.

October 1993 Stabilization: Projections Versus Outcomes Monthly Percentage Changes

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Source: Croatian authorities.

The result of this increase in currency and decrease in bank reserves was a sharp increase in liquidity problems in commercial banks and strong pressure on the exchange rate to appreciate. Apart from foreign exchange and domestic base money, banks had few liquid assets which they could trade among themselves and no asset other than foreign exchange that they could sell to the NBC or each other to increase their domestic reserve deposits. By the end of October, the exchange rate against the deutsche mark appreciated to a rate 7.9 percent higher than the intervention limit for October. Because of the greater than expected inflation in October, this resulted in a real exchange rate approximately 20 percent more appreciated than the rate implied by the inflation projections and the intervention limit.

This large scale withdrawal of currency from banks threatened to cause a collapse of the banking system and the NBC rapidly shifted to a policy of creating enough new base money to prevent either a banking system collapse or undue appreciation of the exchange rate. Starting in November 1993, the NBC intervened in a manner that maintained the exchange rate in a very narrow band against the deutsche mark (although no policy announcement to that effect was made). For a few months starting in mid-November 1993, the NBC even went so far as to conduct its foreign exchange purchases at an exchange rate more depreciated than the market clearing rate (i.e., at a rate disadvantageous to the NBC) in an attempt to narrow the band still further through moral suasion. Thus, the policy announcement and actions during the last quarter of 1993 succeeded in breaking inflationary expectations without causing a financial collapse, although the authorities had to modify their original stabilization program by switching from what had been announced to be a money-based stabilization to an exchange rate-based stabilization in order to bring this about. The change in policy slowed but did not reverse the appreciation of the exchange rate which moved to 3,719 per deutsche mark by end-November 1993 and 3,802 per deutsche mark by the end of December.

Trends in broader money aggregates over this period were similar to those of base money although less pronounced. Broad money, which includes foreign currency deposits as well as domestic currency time and savings deposits, (M3 in Table 37) increased by 46 percent in the fourth quarter of 1993. Surprisingly, in spite of factors that would suggest greater confidence in the domestic currency, foreign currency deposits rose by a greater percentage (53 percent) than domestic currency deposits in the fourth quarter of 1993.

b. Implementation of the stabilization program in 1994 and early 1995

Policies and developments in 1994 and the first half of 1995 have largely continued the policies of November and December 1993. Broad money grew approximately 73 percent in 1993 (Table 37). Base money targets and announced exchange rate intervention limits were discontinued and the exchange rate has been kept at approximately its level of late 1993. Starting in the third quarter of 1994 the authorities began to describe the program as explicitly based on an exchange rate anchor, but this entailed little change the policies actually practiced.

Money demand in Croatia has been difficult to forecast as the remonetization of the Croatian economy continues. Between end-December 1993 and end-April 1995, broad money increased by 85 percent. Within broad money, the foreign currency denominated deposits grew by 66 percent while the domestic currency denominated component grew by 105 percent during this period. As a result of the more rapid growth in domestic currency money, there was some reversal of the currency substitution with the domestic currency share of broad money rising from 49 percent at end-December 1993 to 55 percent at end-April 1995 (Table 37). The rate of change in money holdings has slowed in recent months; broad money increased by only 5 percent in the last quarter of 1994 and 7.2 percent in the first four months of 1995 compared to an average quarterly growth rate of 18 percent in the first three quarters of 1994 (Table 37). 1/

The remonetization experienced in 1994 and early 1995 allowed for substantial growth in both foreign and domestic assets of the banking system. The increases were dominated by increases in domestic credit to non-government extended by the commercial banks and in the net foreign assets of the NBC (Table 37). Claims on government fell by 15 percent during this same period. The decline in claims on government is largely attributable to the use of frozen foreign exchange deposit claims on government to purchase apartments or enterprise shares in the privatization process. 2/ The decline in the counterpart to the frozen foreign exchange deposits was partially offset by an increase in the value of “big bonds” in the second quarter of 1994. This increase in the value of the big bonds was due to a revaluation that reflected producer price increases prior to the October 1993 stabilization rather than new borrowing. 3/ Net foreign assets of the NBC more than doubled between end-December 1993 and end-April 1995, reflecting the rapid buildup in international reserves (Tables 38 and 50).

3. Use of monetary policy instruments

The major monetary policy instruments in Croatia are foreign exchange purchases by the NBC, reserve requirement changes, and sales of NBC bills. Credit to commercial banks from the NBC is limited to small facilities used primarily for intra-month liquidity management. These credit facilities are limited in the number of days per month that they may be used and fully collateralized by foreign exchange or bank holdings of NBC bills. There is also an emergency lender-of-last-resort facility available at the discretion of the NBC.

Foreign exchange purchases by the NBC have accounted for all of the new base money in Croatia since the October 1993 stabilization. Foreign exchange is widely held by banks, enterprises, and households and is the primary tradable financial asset in Croatia. To date, almost all of the interventions in the foreign exchange market have been foreign exchange purchases rather than sales. Between end-December 1993 and end-April 1995, the growth of net foreign assets of the NBC substantially exceeded the growth of all monetary liabilities of the NBC (Table 38).

The NBC also issues bills in various maturities which are sold to banks in auctions several times each month. 1/ The primary purpose of these bills is sterilization, but their importance is limited by the lack of commercial bank demand. 2/ The total stock of NBC bills outstanding has never been much higher than one tenth of base money in spite of interest rates at or above the average credit rates for the banking system. Sales of NBC bills were introduced in late 1993 and are potentially tradable, but commercial banks have shown no interest in interbank trading of NBC bills. The NBC has been forced to serve as its own secondary market in NBC bills through the lombard and repurchase facilities discussed below.

Because of the absence of marketable government debt and the difficulties experienced in altering the volume of NBC bills, the NBC has made frequent use of changes in the reserve requirements in order to sterilize foreign exchange purchases or otherwise contract liquidity. However, reserve requirements are already quite high (on July 12, 1995 the average reserve requirement was 33.9 percent) and, in order to limit the adverse impact of increases in reserve requirements on banks profits, the NBC reintroduced “obligatory NBC bills” in early 1995. Unlike the NBC bills discussed above, these are effectively a supplementary reserve requirement remunerated at a higher rate.

Five less important instruments are repurchase agreements in foreign exchange, lombard credit, repurchase agreements in NBC bills, liquidity credits, and advances to bank’s foreign exchange offices. All of these facilities are shown within credit to banks in the monetary authorities accounts (Table 38). 3/ Both types of repurchase agreements and the lombard facility are used primarily to manage intra-month liquidity fluctuations. The lombard facility is secured by NBC bills and may be used at the discretion of the commercial bank up to twelve days per month. The repurchase agreements in NBC bills are used at the discretion of the NBC in cases where the use of the lombard facility has been exhausted. The advances to banks foreign exchange offices were a seasonal facility used to encourage banks to operate foreign exchange bureaus in areas frequented by tourists.

The relative importance of the various instruments can be seen in the monetary authorities’ accounts (Table 38). NBC credits to banks under refinancing facilities were equal to more than half of reserve money and greatly exceeded commercial bank reserve deposits held at the NBC at end-December 1991 and end-December 1992. By end-December 1993, total NBC credit to commercial banks had fallen to an amount equal to 8 percent of reserve money. By end-December, 1994 credit to banks had fallen to 5 percent of reserve money and consisted exclusively of short-term repurchase arrangements secured by foreign exchange or NBC bills.

General and selective refinance facilities had been major sources of base money injections prior to the October 1993 stabilization. Prior to the stabilization, these facilities were limited, but adjustments to the limits were made to accommodate past inflation. There has been no net extension of credit to commercial banks under either facility since September 1993 and all credit under these facilities was repaid by May 1994. The elimination of these facilities in order to improve base money control was one of the key elements of the stabilization plan.

Direct credit controls have not been used in Croatia except for a two month period beginning in May 1995. The NBC imposed direct credit controls in an attempt to reverse a large, unexpected surge in bank credit. These controls have since been allowed to lapse.

4. Bank liquidity

The liquidity problems in the commercial banks that came to the fore in the early stages of the October 1993 stabilization program continue to plague the Croatian banking system. The portfolios of most banks are dominated by long terms claims on government, which are not tradable between banks and which yield little or no interest, and questionable claims on enterprises. One estimate put the share of non-performing or poorly performing assets in the portfolios of banks at 85 percent. 1/ To some extent, this may also represent a solvency problem that will have to be addressed in the course of bank rehabilitation. 2/ However, the immediate liquidity problems have undermined the efficiency of the banking system and the NBC’s ability to conduct monetary policy.

The troublesome features of the illiquid assets themselves have not changed much during recent years. Claims on government continue to consist of nontradable, long-term, low interest securities and claims on large problem enterprises continue to perform poòrly. However, the share of these assets in the total assets of the deposit money banks has fallen (Table 39). At end-September 1993, claims on government accounted for 65 percent of total assets of the deposit money banks. By end-April 1995 this share had fallen to 44 percent. Credit to a group of large financially troubled enterprises subject to credit ceilings as a part of the stabilization program of enterprises fell from an amount equal to 24 percent of total assets as defined in Table 39 at end-June 1994, to an amount equal to 17 percent of deposit money bank assets by end-April 1995. 1/ These declines in asset shares are attributable more to growth of other credit to other, hopefully healthier, sectors of the economy rather than repayment of the outstanding claims. Nevertheless, the dilution of these assets is helpful in restoring liquidity to the banking system until a more complete solution can be found through avenues such as bank rehabilitation and securitization of claims on Government.

The lack of financial instruments and markets is also a major constraint to the operation of monetary policy, particularly for sterilization operations. There is no marketable government debt and the NBC’s efforts to place its own NBC bills have been met with only modest success as banks are reluctant to compound their existing illiquidity by purchasing larger stocks of NBC bills. Even those NBC bills that are issued are liquid only to the extent that they have short maturities; the NBC has been forced to serve as its own secondary market for the bills. This leaves the NBC with little beyond reserve requirement changes as a large scale sterilization instrument.

The efficient operation of the commercial banks are also undermined by the illiquidity of the banking system. NBC reserve deposits, vault cash, and foreign exchange deposits are the primary liquid assets available to banks, but all of these assets have yields at or below the banks’ costs of funds and well below the yield on alternative assets. Thus banks are forced to choose between maintaining liquidity at a very high opportunity cost (in excess of ten percent at an annual rate) or operating in an illiquid state and risk having no loanable resources for new lending or even possibly falling short of reserve requirements in the event of unexpected liquidity shocks. Particularly in the early months of the stabilization, the illiquidity of banks resulted in extensive use of automatic lender of last resort facilities that forced tighter policies elsewhere and effectively diverted resources from newer, generally healthier banks to illiquid banks with more dubious portfolios.

5. Interest rate developments

Prior to the October 1993 stabilization, the NBC pursued a policy aimed at keeping real interest rates on bank credits slightly positive in real terms. They largely achieved this goal in the first ten months of 1993 for credit rates. However, average deposit rates were much lower, and were sharply negative in real terms (Table 42), contributing to the rise in velocity.

After the October 1993 stabilization interest rates fell sharply although both credit and deposit rates were consistently positive in real terms. By December 1993, average credit interest rates had fallen to 59 percent and average deposit rates had fallen to 27 percent, but this was in a context of falling prices which continued from December 1993 to June 1994. Nominal interest rates continued to decline through August 1994 with credit rates averaging 15 percent and deposit rates averaging 4 percent in August. Since that time, there has been an increase in both credit and deposit rates in spite of continuing low inflation.

The NBC pursued a policy of attempting to reduce interest rates and interest rate spreads through the use of low NBC discount rates and moral suasion (Table 41). The expectations of the NBC in this regard were limited; they view the high interest rate spreads primarily as the result of a relatively large share of non-performing or under-performing loan assets in the portfolios of most major commercial banks and lack of competition. In any case, the discount rate is largely symbolic; it is used primarily for transactions between the NBC and the Government.

In late 1994 and 1995, these interest rate goals were de-emphasized in favor of measures to restrict base money creation and increase sales of NBC bills for sterilization purposes. Recently, interest rates have started to rise again as the NBC attempted to control the growth of banking system credit through increased reserve requirements and sales of NBC bills to commercial banks. The effect of these steps has been to increase interest rates both on NBC bills and throughout the banking system more generally (Table 41).

Commercial bank credit and deposit rates follow similar patterns. Average commercial bank credit rates on domestic currency credits reached a low of 14.9 percent in August 1994. This was followed by a modest increase in the average rate to 15.4 percent by December 1994 and a much sharper increase to 18.7 percent by May 1995. Average deposit rates on domestic currency deposits fell to 3.9 percent in August 1995, rose to 5.0 percent in December 1994 and 5.3 percent in May 1995. The average spread between these credit and deposit rates rose from 11.0 percent in August 1994 to 13.4 percent in May 1995 (Table 42).

Information on interest rates on foreign currency deposits and credits is less detailed but shows a similar trend. Most deposits in foreign currency are household deposits and all reported credits in foreign exchange are credits to enterprises. Foreign currency interest rates declined modestly between the third quarter of 1993 and the third quarter of 1994, but then began to rise. The unweighted average of three maturities of (mostly deutsche mark) foreign currency household deposits rose from 6.50 percent in the third quarter of 1994 to 6.91 in the second quarter of 1995. No information is available on foreign currency denominated credit rates prior to the second quarter of 1995. Since then, foreign currency interest rates on enterprise credits rose from an unweighted average of 12 percent in the second quarter of 1994, to 13.75 percent in the fourth quarter of 1995 to 15.0 percent in the second quarter of 1995 (Table 43).

V. External Sector

Croatia’s balance of payments produced modest surpluses on both the current account and capital account in 1994 which allowed a large increase in official reserves. Within the current account, a substantial deficit on trade in goods was more than offset by a surplus on the services account, largely attributable to tourism inflows and to a lesser extent private transfers.

1. Exchange rate developments

The authorities have maintained the exchange rate of the kuna in a narrow range against the deutsche mark since late 1993 (Table 50). As a result, the kuna appreciated in nominal terms against other major currencies, particularly the U.S. dollar, during 1994. From end-December 1993 to end-December 1994 it appreciated by 5 percent against the deutsche mark and 17 percent against the U.S. dollar. The real effective exchange rate remained relatively constant during 1994 (depreciating by 3 percent) as the net impact of Croatian deflation and industrial country inflation more than offset the nominal appreciation of the kuna. The relative stability against the deutsche mark continued in the first half of 1995 with an appreciation in the exchange rate of the kuna of less than one percent between end-December 1994 and end-June 1995.

The relative stability of the kuna was accomplished in part through large purchases of foreign exchange by the NBC which increased its gross reserves by US$793 million in 1994 (of which US$117 million is accounted for by purchases from the Fund in October). Most of the purchases of foreign exchange from the domestic market took place in the middle part of the year when inflows of foreign exchange from summer tourism would have otherwise put upward pressure on the exchange rate. Gross reserves of the NBC increased by a further US$421 million in the first half of 1995 largely in April as the result of Fund purchases and May and June as a result of purchases of foreign exchange by the NBC in the domestic market.

2. Current account developments

The current account was unchanged in 1994 against 1993 with a surplus of US$104 million in both years. This resulted from a widening of the trade deficit from US$763 million to US$969 million that was precisely offset by an increase in the surplus on services from US$868 million in 1993 to US$1,074 million in 1994 (Table 44).

a. Exports

Croatia’s 1994 exports rose by 9 percent from 1993 levels to reach US$4,260 million (Table 45) in spite of the real appreciation. 2/ Exports to former Yugoslav Republics remained almost unchanged at US$968 million, but exports to other countries rose from US$3,894 million to US$4,657 million. Just over half of this increase can be attributed to increases in exports of machines and other transport equipment, lead by shipbuilding, which increased from US$552 million in 1993 to US$732 million in 1994. The other increases and decreases in exports are spread widely across Croatia’s widely diversified exports (Table 46). The increase in exports was also spread widely over destinations with most regional groupings showing some increase (Table 48).

Exports in the first four months of 1995 were running 63 percent above the rate in the same four months of 1994, suggesting that the real appreciation still wasn’t depressing exports (Table 45). However, the trade balance deteriorated relative to the same four months of 1994. The authorities attribute at least some of the trend increase in reported trade to better data collection although they believe that exports would still be increasing rapidly even with comparable measurement in both periods.

b. Imports

Imports in 1994 increased by 12 percent to US$5,229 million in 1994 (Table 45) reflecting in part the pickup in domestic economic growth in Croatia. This increase was supplied exclusively by imports from countries other than former SFRY; imports from other republics of the former SFRY fell by 26 percent to US$572 million in 1994. The product composition of imports with no one sector or group of sectors standing out as a predominant source of the increase (Table 47). The growth in imports was also diversified by country of origin with all country groups showing an increase except for the previously noted former SFRY republics where the decrease was almost entirely explained by a decline in imports from Slovenia (Table 49).

The increase in imports continued in the first four months of 1995, but at an accelerated pace (Table 45). Imports in the first four months of 1995 were running at a rate 107 percent above the same four months of 1994. Although the authorities regard this as a cause for concern, they attribute it to both rapidly rising production likely to be reflected in future exports (noting in this regard that the increase is heavily concentrated in intermediate goods and capital equipment) and improved data collection.

c. Services

The surplus on services income, and transfers increased from US$868 million in 1993 to US$1,074 million in 1994 (Table 44). The major factors behind the increase in the surplus were increases of US$342 million in the surplus on tourism and increases of US$98 million in the surplus on private transfers. These were partially offset by a substantial increase in the deficits on other services (a change of US$177 million) and a smaller change in the surplus on transportation services. Other components showed little net change between 1993 and 1994.

3. Capital account

The capital account shifted from near balance in 1993 (a surplus of US$18 million) to a surplus of US$218 million in 1994 (Table 44). This shift can be largely attributed to an increased inflow in other sectors’ net claims. This category of inflows includes a wide range of small transactions reflected in banks purchases of foreign exchange. Government drawings less repayments were almost unchanged between the two years. Foreign direct investment and bank net claims showed modest shifts which also contributed to the increased surplus.

4. External debt and Service

External debt (Table 51) shows an increase of US$740 million during 1994. However, most of this increase reflects a redefinition of the debt stock or increases in interest arrears rather than new borrowing or repayment. Particularly noteworthy in this regard are the increases in debt to Paris Club creditors which increased by US$470 million during this period. Paris Club debt data for end-1994 reflect the share of nonallocated debt of the former SFRY owed to Paris Club creditors while the earlier figures do not. Similarly, the increase of US$230 million in interest arrears is also affected by this change in definition. Although some payments to Paris Club creditors were made in 1994, the rescheduling agreement with the Paris Club was only concluded on March 21, 1995.

Croatia’s external debt is relatively low and declining relative to GDP. The debt to GDP ratio has fallen from 24.2 percent in 1993 to 21.6 percent in 1994. This decline is primarily the result of the real appreciation of the exchange rate rather than repayment of the debt. 1/ Debt service is also low relative to exports. Debt service fell from 15.9 percent of merchandise exports in 1993 to 13.0 percent in 1994.

Croatia: Recent Economic Developments
Author: International Monetary Fund
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    Croatia: Real GDP, 1989-95

    (Millions of constant 1990 kunas)

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    Croatia: Competitiveness, Real Wages, and Productivity 1987-94

    (Millions of constant 1990 kunas)