Republic of Croatia: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
05 Oct 1998
eISBN:
9781451817249
Language:
English
Keywords:
ISCR; CR; Croatia; bank; wage; expenditure arrears; share; EU trade; trade arrangement; EU market; EU firm; EU Association Agreement; Export performance; Foreign direct investment; Trade agreements; Tariffs; trade-complementing FDI inflow
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This Selected Issues paper and Statistical Appendix analyzes developments in Croatia’s banking sector since independence in 1991, focusing on the effects of independence, war, transition, and the bank rehabilitation process. Changes in market structure, concentration, and ownership, as well as financial performance are highlighted. The paper reviews the current legal environment governing banking operations and improvements needed to strengthen the legislative framework. Some forward-looking conclusions are presented. The paper also examines selected aspects of Croatia’s export performance.

Abstract

This Selected Issues paper and Statistical Appendix analyzes developments in Croatia’s banking sector since independence in 1991, focusing on the effects of independence, war, transition, and the bank rehabilitation process. Changes in market structure, concentration, and ownership, as well as financial performance are highlighted. The paper reviews the current legal environment governing banking operations and improvements needed to strengthen the legislative framework. Some forward-looking conclusions are presented. The paper also examines selected aspects of Croatia’s export performance.

II. Croatia: Selected Aspects of Export performance and Prospects17

A. Introduction

40. Between 1993 and 1997, Croatia’s total export receipts increased by 13 percent (Table 3), compared with an average increase of 79 percent for other Central and Eastern European Countries (hereafter referred to as the CEECs).18 This chapter examines Croatia’s export performance in more detail (Section B), focusing on three potential explanations for its poor relative export performance: worsening indicators of external competitiveness (Section C); the implications of the war and the effects of post-war reconstruction on the demand for goods produced in export sectors (Section D); and Croatia’s trade relations with the European Union (EU) and other CEECs (Section E). In addition, the link between trade performance and foreign direct investment (FDI) is considered (Section F). In particular, this section discusses how improved access to EU markets by some CEECs has influenced FDI flows into those latter countries, and whether or not there have been (or could be) any detrimental effects on Croatia’s FDI inflows and related exports because it has not been party to the same trade agreements as a number of other countries in the region. The chapter ends with some concluding remarks (Section G).

Table 3.

Central and Eastern Europe: Exports of Goods

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Source: IMF, World Economic Outlook.

B. Recent Comparative Export Performance

41. The collapse of the Council of Mutual Economic Assistance (CMEA) and the Soviet Union in 1991 resulted in a large contraction of trade within the transition economies of Central and Eastern Europe.19 In response, the CEECs undertook a process of reform which had a profound effect on their foreign trade regimes: tariff levels were reduced, many quantitative restrictions were eliminated, direct trade subsidies were lowered or abolished, and exchange systems were liberalized.20

42. More recently, the benefits of this reform process have begun to be felt. Table 3 highlights the export performance of individual CEECs during 1993–97: Estonia, Hungary, and Poland recorded the fastest export growth, with growth rates in excess of 120 percent.21 Over the same period, the average (unweighted) rate of growth for the whole sample of CEECs was 79 percent (Figure 1). By comparison, Croatia’s exports grew by just 13 percent, the lowest rate of growth recorded by any of the countries in the sample. Furthermore, export volume in Croatia actually declined during 1995 and 1996.22

Figure 1.
Figure 1.

Central and Eastern Europe: Export Performance 1/

(1993=100)

Citation: IMF Staff Country Reports 1998, 090; 10.5089/9781451817249.002.A002

Sources: IMF Direction of Trade Statistics, World Economic Outlook, and IMF staff estimates.1/ Original exports series are denominated in deutsche mark.2/ The indices for CEEC exports in each chart are simple averages of individual country data.

43. Perhaps the most significant consequence of the collapse of the command economy system was the reorientation of trade toward the west, in particular toward the EU (Table 4). Between 1993 and 1997, total CEEC exports to the EU increased by 18 percent a year, with Hungary, the Slovak Republic, and Romania registering export growth in excess of 25 percent per year. This rapid growth in trade meant that the EU became the dominant export market for the CEECs.23

Table 4.

Central and Eastern Europe: Exports of Goods to the European Union

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Source: IMF, Direction of Trade Statistics.

44. Croatia has largely missed out on the rapid expansion of CEEC exports to this market. Between 1993 and 1997, its exports to the EU increased by an average of just 1 percent per year. Thus, Croatia’s share of the EU market declined from 0.27 percent in 1993 to just 0.19 percent by 1997 (Table 5).24 In contrast, Bulgaria, the Czech Republic, Hungary, Poland, Romania, and the Slovak Republic all enjoyed significant increases in their market share; Slovenia more or less maintained its share at its 1993 level.

Table 5.

Central and Eastern Europe: Growth of EU Market Share

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Source: IMF, Direction of Trade Statistics.

Index of individual country exports to the EU, divided by the index of all EU imports (including intra-EU trade).

Includes intra-EU trade.

Excludes intra-EU trade.

45. Within the CEECs, intraregional trade liberalization has been another major factor in the recovery of exports. The proliferation of trade agreements—most notably the Central European Free Trade Agreement (CEFTA), but also some bilateral trade agreements—has reduced trade barriers within Eastern Europe.25 These export markets have grown faster than either the EU market or markets in the rest of the world, reflecting a return to some of the trade patterns that prevailed during the socialist era.

46. Not surprisingly, some of the fastest rates of export growth to the CEFTA area have been enjoyed by CEFTA member countries themselves (Table 6). For example, since 1993 the Czech Republic and Slovenia have almost doubled their export receipts, while in Hungary and Poland these receipts have about tripled. Non-CEFTA countries have also enjoyed strong export growth to CEFTA countries; for example, both Estonia and Romania (which only recently joined CEFTA) doubled their exports receipts to these countries.

Table 6.

Central and Eastern Europe: Exports of Goods to CEFTA

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Source: IMF, Direction of Trade Statistics.

47. In contrast, Croatia’s export growth to the CEFTA countries has been both volatile and comparatively small. During the Yugoslav conflict, these exports declined significantly. With the onset of peace in 1995, Croatian exports to the CEFTA area grew rapidly (41 percent and 37 percent in 1995 and 1996, respectively). However, growth was more subdued in 1997, when exports grew by 2 percent. Notwithstanding positive growth in 1995–97, Croatia’s exports to the CEFTA countries have yet to return to the level achieved in 1993.

C. External Competitiveness

48. To what extent can Croatia’s relatively weak export performance be accounted for by changes in external competitiveness? One view suggests that a real exchange rate appreciation reduces export competitiveness by raising the price of domestic exports relative to foreign exports, thereby reducing demand for domestic exports. However, some commentators argue that the real exchange rate appreciations that have occurred in several transition economies since 1992 are a special case and that the implications for external competitiveness may well be overstated. According to this line of reasoning, during the final stages of central planning, the exchange systems of the CEECs were heavily regulated and currencies were not convertible. As a consequence, during the initial stages of transition, there were large discrepancies between purchasing power parity and the prevailing exchange rates. Thus, it is difficult to judge the evolution of external competitiveness by taking as a starting point the initial phase of transition (Oblath, 1994).

49. Halpern and Wyplosz (1996) expand this idea in arguing that exchange rate developments in many transition economies have followed a common pattern. During the early stages of transition, when significant macroeconomic weaknesses were present, the real exchange rate suffered an initial massive depreciation. However, once the macroeconomic situation stabilized, and the process of structural transformation began, the real exchange rate began to appreciate. Halpern and Wyplosz suggest that this real appreciation is in response to two different effects. The first effect could be described as the overshooting effect: the initial depreciation often overshot its equilibrium level, and so a subsequent appreciation was inevitable. The second effect could be described as the productivity effect. Once the transition process took hold, significant productivity and efficiency gains were realized, which encouraged an appreciation in the long-run equilibrium exchange rate. If this latter effect was significant, any observed appreciation would be consistent with maintaining external competitiveness.

50. Owing to data limitations, the only readily available measure of the real exchange rate for all the CEEC economies is the CPI-based real effective exchange rate (REER-CPI). Table 7 and Figure 2 provide data on the REER-CPI for the selected sample of CEECs. Following Croatia’s stabilization program of October 1993, when the government decided to limit the exchange rate to a narrow range against the deutsche mark, the real effective exchange rate appreciated dramatically (in 1994 it was 20 percent higher than the previous year). Thereafter, the REER has remained quite stable. This stability suggests that changes in external competitiveness as measured by the REER-CPI cannot account for Croatia’s relatively weak export performance much beyond 1994.

Table 7.

Central and Eastern Europe: Exchange Rate Developments

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Sources: IMF, Information Notice System and World Economic Outlook.

Period average.

Figure 2.
Figure 2.
Figure 2.

Central and Eastern Europe: Real Exchange Rate Developments 1/

(1993 = 100)

Citation: IMF Staff Country Reports 1998, 090; 10.5089/9781451817249.002.A002

Source: INS database.1/ CPI based calculation.

51. This point is reinforced by the observation that several other CEECs recently experienced significant exchange rate appreciations while registering substantial export growth. For example, during 1993-97, the real effective appreciations for Estonia, the Czech Republic, Latvia, Lithuania, and Poland were the same as, or larger than, for Croatia—though the rate of appreciation was more gradual Bulgaria, Romania, and the Slovak Republic also experienced significant appreciations, albeit less than Croatia’s.

52. An attempt was also made to assess relative external cost competitiveness by exploring various labor market indicators (Table 8), recognizing that there are important data limitations and that the results must therefore be interpreted with considerable caution. For example, the accuracy of the underlying data is, of course, an issue. In addition, coverage is confined to manufacturing or industrial sectors, and therefore excludes the services and informal (or unrecorded) sectors, which can affect external competitiveness. Furthermore, productivity is measured on a gross output rather than a value added basis; thus industries can, in theory, record significant productivity gains while actually making losses.

Table 8.

Central and Eastern Europe: Labor Market Competitiveness Indicators

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Source: European Bank for Reconstruction and Development.

Data refer to average monthly industrial wages in Bulgaria, Croatia, Czech Republic, Slovak Republic, Slovenia, and average monthly manufacturing wages for Hungary, Poland, and Romania.

Data for 1997 refer to the first three quarters.

Based on gross output.

Index of DM wages deflated by productivity index.

53. With these caveats in mind, Table 8 clearly indicates that wages are high in Croatia compared with other transition countries: in 1997, the only country with higher deutsche mark-denominated wages was Slovenia. Real manufacturing wage growth also points to a significant deterioration in cost competitiveness. In the four years after 1993, real wages deflated by domestic producer prices increased by over 103 percent, suggesting a possible squeeze on the manufacturing sector’s profit margins. In contrast, average real wage growth over the same period in the rest of the CEECs was 23 percent.

54. It must be noted that a simple comparison of wage levels can provide a potentially misleading indicator of labor costs, since it does not take into account differences in productivity. While productivity growth could be an offsetting factor, cross-country comparisons suggest that such growth has not been considerably stronger in Croatia.

55. Combining the data on wage costs and productivity indicates that Croatia has recorded one of the highest rates of growth of unit labor costs in the region: an increase of 70 percent from 1993 to 1997, compared with smaller increases, often times by substantial margins, in Bulgaria, the Czech Republic, Hungary, Poland, Romania, the Slovak Republic, and Slovenia. While the Baltic countries experienced much more rapid growth in unit labor costs during this period, deutsche mark-denominated wages in the Baltic countries were extremely low in the base year relative to the rest of the CEECs. Thus, despite the rapid growth of their wage costs over the last four years, their strong export performance in recent years suggests that the rise in unit labor costs has not put the Baltic countries at a competitive disadvantage.

56. Concerns about external competitiveness in Croatia are borne out by a recent study by Vujčić and Presečan (1997). Their study indicates that much slower growth, on average, of Croatian exports of manufactured goods relative to other transition countries has been accompanied by slower trade specialization within various product groups. Using indices of intra-industry trade, and correlating these with export performance, they conclude that Croatia has lagged behind the comparator group economies in improvements in competitiveness.26

D. The Impact of War

Precise estimates of the effects of the war on export performance are difficult to obtain, but there is considerable anecdotal evidence suggesting that the impact was considerable. The tourist industry was deeply affected by the conflict, with estimates of lost tourist receipts as high as US$13 billion (Radnić and Ivandić, 1997). In 1989, the year immediately prior to the conflict, Croatia received over 54 million overnight foreign tourist stays. In 1991, this figure had fallen to just under 7 million overnighters. While the tourist industry has recovered somewhat in recent years—in 1997 Croatia received 25 million foreign overnighters—the industry is still operating considerably below pre-war levels. Furthermore, direct physical damage inflicted upon the tourist industry was estimated to be at least US$235 million (Radnić and Ivandić, 1997).

58. In terms of merchandise export performance, perhaps the most significant effect of the war was the disruption of the main traffic links between the central, eastern, and southern parts of the country. The war also disrupted the large volumes of trade transported on the Danube River. These transportation problems created severe difficulties for trade relations within the former SFRY, which were particularly important prior to the war, A study undertaken by the Zagreb-based Statistics Institute indicates that in the immediate pre-war period, over half of all goods produced within Croatia, and whose final user was outside the republic, went to other former Yugoslav republics (Stjepanović, 1990). However, many of these transport connections were re-established after July 1995.

59. During the early years of the conflict, the Croatian government’s need to finance the war created significant macroeconomic instability as government deficits were financed through monetary expansion. Macroeconomic instability deeply affected Croatia’s access to international capital markets during the early 1990s. In particular, export finance was difficult to obtain. Furthermore, the conflict required a reallocation of labor toward military purposes. While there are no precise data on the extent of the mobilization, it was undoubtedly considerable.

60. There is tentative information that suggests that post-war reconstruction has also affected export performance. An analysis of the sectoral composition of Croatia’s exports reveals that import growth outstripped export growth in many sectors, suggesting that goods previously produced for export may have been diverted toward domestic markets (Table 9). The most adversely affected sector would seem to be construction materials, which accounted for about 14 percent of total exports in 1997, During 1995–96, construction exports fell by 15 percent while imports increased by 60 percent.

Table 9.

Croatia: Composition of Trade According to Categories Defined by SITC

(In millions of deutsche mark)

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Source: The authorities.

E. Trade Relations

61. The CEECs have actively sought closer political and economic relationships with the EU and, to a lesser extent, with the member countries of the European Free Trade Association (EFTA).27 At the same time, the CEECs have tried to rebuild traditional markets within Central Europe through initiatives such as bilateral trade agreements and the CEFTA.28 In contrast to several other CEECs, Croatia has not negotiated any new trade arrangements with either the EU or EFTA, nor has Croatia participated in regional free trade agreements.

62. It is worth noting that Croatian firms enjoyed the benefits of preferential trade agreements with the EU long before the rest of Central and Eastern Europe. The SFRY concluded a number of trade agreements from 1970 onward, including a trade and cooperation agreement in 1980. Following the dissolution of the SFRY, the EU unilaterally decided to continue to apply the commercial terms of the agreement to all the former Yugoslav republics. This may in part help explain the poor growth performance of Croatian exports to the EU, relative to other CEECs: the longer period of preferential access would have resulted in historically higher volumes of Croatian exports to the EU relative to other CEECs, and so lead to lower relative growth rates in recent years.

63. Table 10 provides a summary of the current status of trade relations between the EU and the major CEECs. The EU has offered a number of facilities for promoting trade and development within the CEECs (Box 1). However, the main vehicle for encouraging closer EU-CEEC trade links has been the Association Agreements (also known as Europe Agreements), which are, in effect, stepping stones to eventual full membership of the EU.29 Croatia, the other former Yugoslav republics (with the exception of Slovenia), and Albania are the only CEECs that have not signed Association Agreements with the EU.30

Table 10.

Central and Eastern Europe: Trade Arrangements

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Sources: EU sectoral and trade barriers database; IMF TPD database; and Temprano and Feldman (1998).

Date refers to when agreement came into force.

A negative opinion implies that the European Commission’s assessment of the country in question is that it is not ready to start accession discussions.

The Czech Republic and the Slovak Republic have a customs union agreement.

The Czech and Slovak Federal Republic (CSFR) signed a Trade and Cooperation Agreement in May 1990 and an Association Agreement in December 1991. Following the dissolution of the CSFR, separate Association Agreements and supplementary protocols to the Interim Agreement were signed with each of the successor republics.

An Association Agreement was signed in June 1996, but it is still in the process of ratification.

64. In terms of trade policy, the primary benefit of an Association Agreement is that the EU is obliged to phase out all statutory tariffs on CEEC industrial goods. The Agreements are “asymmetric” in the sense that the EU is required to eliminate tariffs more rapidly than the CEECs.31 However, the EU continued until recently to impose quotas on so-called sensitive industrial goods, such as textiles, clothing, and footwear. Furthermore, contingent protection instruments such as voluntary export restraints (VERs) and anti-dumping duties are permitted under the Association Agreements.

65. The impact of the Association Agreements upon CEEC-EU trade has been the subject of some debate. Inotai (1994) and Messerlin (1992) make the points that the Association Agreements do not provide any special treatment for the CEECs and that the extent of tariff reduction and increased access to EU markets was initially rather limited. The extensive protection initially offered by the EU to those goods on the sensitive list has been criticized by Faini and Portes (1995) and others. Furthermore, the lack of progress in reducing tariffs on agriculture—a major sector within the CEECs—has limited the impact of the trade liberalization embodied within the Agreements (Drábek and Smith, 1995).

Economic Relations Between Central and Eastern Europe and the European Union

The EU has created a number of mechanisms through which it fosters closer economic ties with the CEECs.

PHARE - This initiative provides grants to CEECs, mostly to finance technical assistance. Its objectives are to help these countries develop market institutions, adopt EU legislation and standards, and “strengthen democracy to the stage where the participating countries are ready to assume membership of the European Union.”

OBNOVA - Created in July 1996, this program aims to reinforce the Dayton Accord through grant assistance. The program covers four countries; Bosnia and Herzegovina, Croatia, the Federal Republic of Yugoslavia, and the former Yugoslav Republic of Macedonia (FYRM). The main objectives of the program are: regional cooperation projects, infrastructure rehabilitation, the return and reintegration of refugees, and the consolidation of democracy.

Trade and Cooperation Agreements (TCA) - The EU granted most favored nation status and the phasing out of selective (discriminatory) quantitative restrictions. These Agreements have in most cases been replaced by Association Agreements.

Autonomous Preferential Trade Regimes (APTR) - After the dissolution of the SFRY, the EU renounced the Trade and Cooperation Agreement of 1980. However, it continued to apply the commercial terms of the agreement unilaterally to each of the new republics that arose out of the SFRY, including Croatia. The EU refers to this trade arrangement as the “Autonomous Preferential Trade Regimes.” The APTR are subject to annual review.

Interim Europe Agreements - These Agreements allowed for the early implementation of the trade-related aspects of the more comprehensive Europe Agreements.

Association Agreements - Also known as Europe Agreements, these aim to integrate the economies of Central and Eastern Europe with the European Union. The Agreements aim to establish a free trade area for industrial goods, with a transition period of 10 years. These Agreements also cover the progressive liberalization of the trade in services, liberalization of payments, free movement of capital, and the protection of intellectual property rights. However, the Agreements foresee only limited liberalization of trade in agricultural products. Also, some sensitive industrial products, such as steel and textiles, were subject to slower liberalization timetables. While Association Agreements may form the basis of future full membership in the EU, the agreements do not imply any EU commitment to admit the associated countries to full membership in the future.

66. Nevertheless, the absence of an Association Agreement can adversely affect Croatian exports to the EU in three ways. First, there is the supply-switching effect: the majority of CEEC products will no longer be subject to EU tariffs, while all Croatian exports will continue to do so. Thus, at the margin, there will be a shift away from Croatian exports toward other CEEC exports. Table 11 provides information on the coverage and rates of EU tariffs applied to non-EU imports.32 For many Croatian exports, the lack of preferential access creates a significant price differential relative to similar goods produced in other CEECs.

Table 11.

EU Tariffs by ISIC Categories

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Source: World Trade Organization, “Trade Policy Review” (October 1997).

67. Second, the Association Agreements call for the harmonization of product standards and the elimination of other nontariff trade barriers. The elimination of such barriers will lower border prices and induce further supply switching away from Croatian exports toward goods produced by other CEEC countries.

68. Finally, the Association Agreements have strict rules of origin clauses (Box 2), which will divert trade away from Croatia and toward other countries that have concluded Association Agreements. In order to qualify for EU trade preferences, CEEC products must contain a significant value added component, produced either locally or within the EU. In order to encourage intra-CEEC trade, the EU introduced cumulation provisions, which enable countries that are party to Association Agreements to consider inputs from other countries with similar agreements as local content.

69. In addition, Croatia is not a member of CEFTA. Total trade to CEFTA countries constitutes only 18 percent of Croatia’s exports, which may reflect the comparatively high tariff restrictions in place (Table 12).33 The proximity of these markets suggests that the potential gains from membership could be significant.

Table 12.

Central and Eastern Europe: Tariff Structure Summary

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Source: IMF, Trade Policy Division.

70. Membership in CEFTA (Box 3) in the near future seems a remote prospect for Croatia. While negotiations on WTO membership are at an advanced stage, the possibility of an EU Association Agreement is very unlikely within the foreseeable future; thus, Croatia fails to meet one of the three criteria for CEFTA membership. While Croatia is in the process of negotiating bilateral agreements with each CEFTA member, only one agreement (with Slovenia) has been concluded so far. Negotiations are currently underway with Hungary and Poland. However, in the case of Poland, progress has stalled over agricultural issues.

European Union Rules of Origin

Rules of Origin (ROOs) establish the economic nationality of products. In a customs union or a free-trade area, ROOs determine when members provide preferential treatment for goods produced by fellow members. Under a free trade agreement, where each member maintains its own external tariffs, ROOs prevent nonmember countries from enjoying lower tariff rates by subjecting exports from nonmember countries routed through member countries with low external tariffs—but destined for member countries with higher external tariff barriers—as subject to the tariff rates of the final-destination country.

Each EU preferential trade agreement, including Association Agreements, has special protocols defining ROOs. A product can be given preferential treatment if it is either “wholly obtained” or has undergone a “substantial transformation” in an associated country.

In order to qualify for preferential treatment, firms must provide significant documentation proving that they are in compliance with ROO requirements. If compliance costs are high, then ROOs are, in effect, nontariff barriers (Hoekman, 1993). If conventional tariffs are low, then exporters may prefer to pay them, rather than pay the costs of providing ROO documentation proving the economic nationality of the goods.

The EU has recognized that if different ROOs are applied to each associated country, then both trade diversion and “hub and spoke” investment deterring effects may arise within the CEEC. In response, the EU has taken steps in recent years to facilitate the cumulation of origin among associated countries. This culminated in 1997 in the so-called pan-European cumulation of rules of origin agreement, which currently covers 31 countries including the 15 EU countries, the 10 associated CEECs, and the four EFTA countries. Under this agreement, materials from any of the 31 countries may be counted as local content by the associated country processing them. Obviously, these cumulation rules discriminate against those countries, such as Croatia, which do not have preferential EU trade arrangements.

F. Market Access and the Link with FDI

71. FDI is defined as the acquisition by foreigners of a controlling interest in a domestic firm. This controlling interest can manifest itself in two ways: the foreigner may acquire existing assets or may provide resources for the creation of new assets.34 For the host country, FDI provides valuable technology transfers and improved management and marketing techniques. In the case of the CEECs, FDI is an important counterweight to the weaknesses of domestic capital markets. Domestic saving, which tends to be low by international standards, can be complemented by foreign saving. Foreign investors can access international capital markets more cheaply than domestic investors, who tend to be viewed as being more risky. Furthermore, FDI tends to be sectorally concentrated in manufacturing. Given the CEECs’ relative abundance of highly educated, low wage workers, FDI can play a vital role in exploiting the region’s comparative advantage (Halpern, 1994).

CEFTA

The Central European Free Trade Agreement (CEFTA) was signed on December 21, 1992, and came into effect in March 1, 1993. It has two objectives: the creation of a free trade area through the gradual elimination of tariff and nontariff trade barriers on all industrial goods and on a limited number of agricultural products. CEFTA will also eliminate discrimination against intra-CEFTA trade compared with EU trade. Originally, members were the Czech Republic, Hungary, Poland, and the Slovak Republic; Romania and Slovenia joined later.

There are three requirements for membership in the CEFTA; i) bilateral free trade agreements with each existing member of CEFTA; ii) WTO membership; and iii) an Association Agreement with the EU.

The Agreement provides for a phased reduction in customs duties. Tariffs on chemicals, raw materials, and machinery and equipment were eliminated entirely on March 1, 1993, while tariffs on industrial goods were eliminated in stages between 1993 and 1995. Tariffs on sensitive products (such as textiles, cars, and metallurgical products) will be gradually phased out between 1995 and 2001. Trade liberalization on agricultural products is confined to those products not produced in the importing country.

The Agreement embodied a general principle that tariffs for trade among member countries would be matched by those imposed by the EU through the Association Agreements. Under the Agreement’s ROOs, a commodity enjoys a lower tariff if at least 60 percent of the value added had been produced within CEFTA.

72. The implications of FDI for trade are ambiguous: it may either be a substitute for, or a complement to, trade. If the FDI flows are used to provide the necessary capital to create new domestic industries which will accommodate domestic demand, then FDI is a substitute for trade in the sense that the host country will substitute domestic products for imports. If the FDI is used to expand industries whose products will be sold abroad, then it is a complement to trade.

73. Stern (1997) argues that recent FDI flows into the CEECs can be characterized as having three distinct phases. The first stage, which he refers to as the initiation phase, corresponds to the early period of transition in which the political and economic uncertainty, the absence of an institutional framework, coupled with the lack of macroeconomic stabilization, make investment a risky prospect and, as a consequence, the size of foreign investment flows tends to be low. The limited FDI that does arrive reflects the privatization process and the desire of foreign investors to gain a foothold in domestic consumer markets, which can be achieved with comparatively small investments.

74. During the second stage, referred to as the internationalization stage, the host country becomes much more conducive to longer-term investments. The motive for these investments can be either trade-substituting or trade-complementing—i.e., either to capture domestic market share, or to exploit the comparative advantage of the host country.

75. The final stage is referred to as the mature investment stage. This phase occurs when the transition process is all but complete, and all the key elements of the market economy are in place. During this phase, FDI will largely flow into the export sector and therefore will complement trade.

76. The danger for Croatia is that because it is not party to the same agreements with the EU as a number of other CEECs, FDI inflows may well be adversely affected through attempts by the EU and the CEECs to resolve the problem of “hub-and-spoke” investment-deterring effects.35 For example, if each of the CEEC economies (the spokes) negotiated free trade agreements with the EU (the hub), an EU firm would have access to all the markets within the CEEC and the EU, whereas a firm in a CEEC country would have access to just the EU and the home market. Other things being equal, the FDI would be attracted to the hub economies rather than the spokes.

77. The Association Agreements try to resolve this problem through ROOs, which allow for cumulation (Box 2). Since Croatia is not even a spoke, the Association Agreements’ ROOs and cumulation clauses tend to attract FDI flows into other CEEC economies. In terms of Stern’s taxonomy, Croatia could find itself stuck in the first phase. Trade-substituting FDI, which develops domestic markets, may still be profitable. However, the lack of a preferential trade agreement with the EU will discourage trade-complementing FDI flows, which typically expand the export-oriented sector.

78. Despite these theoretical arguments, there is little evidence so far that Croatia has received significantly lower FDI compared with other CEECs. While the distribution of FDI into the CEECs has been very uneven—with the Czech Republic, Estonia, Hungary, and Latvia receiving a disproportionate amount relative to the other CEECs (Table 13)—the amount of FDI flows in terms of GDP received by Croatia after the war years is broadly similar to that of other CEECs. This emphasizes the point made by Agarwal (1996), whose study of the determinants of German FDI to the CEECs reports that Association Agreements are not a sufficient condition for attracting FDI. He found that Bulgaria and Romania received comparatively small amounts of FDI despite having signed Association Agreements and argued that the likelihood of future EU membership was an even more important determinant of FDI. Either way, since Croatia is not party to an Association Agreement with the EU or other regional trade arrangements, the flow of FDI into the country could ultimately suffer.

Table 13.

Central and Eastern Europe: Foreign Direct Investment 1/

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Source: IMF, World Economic Outlook.

Gross inflows.

G. Summary and Concluding Remarks

79. Croatia’s export performance was weak during the war years, both in terms of overall growth and declining market share in the EU as well as the CEFTA markets. While there were some tentative signs in 1997 that Croatian export performance might be improving—total exports valued in deutsche mark grew by 7 percent, with a similar rate of growth recorded for exports to the EU market—export performance recorded by other CEECs was significantly better.

80. There is little evidence in terms of the CPI-based real effective exchange rate that external competitiveness has recently deteriorated, as this measure has remained broadly unchanged since 1994. However, labor market indicators suggest that relative external cost competitiveness has, in fact, worsened.

81. There is considerable anecdotal evidence to indicate that the war had a significant negative impact on Croatian exports. Traditional transport routes were cut, the war created considerable macroeconomic instability, and labor was reallocated to military activities. In addition, post-war reconstruction may have diverted goods, particularly in the construction materials sector, away from export markets and toward domestic sales.

82. A particularly worrying development in terms of medium-term balance of payments sustainability is the fact that Croatia does not enjoy the same trade and economic arrangements with the EU as several other CEECs. In particular, while many of these countries now have EU Association Agreements in place and favorable prospects for joining the EU in the not too distant future, Croatia seems unlikely to secure an Association Agreement soon. The ROOs clauses of those agreements tend to discourage firms in other CEECs from using inputs produced by Croatian firms. A related problem for Croatia is that the absence of an Association Agreement with the EU in the future could be detrimental to Croatia’s ability to attract trade-complementing FDI inflows. As EU membership approaches for many of the CEECs, Croatia could increasingly find itself in a more disadvantageous position when it comes to attracting FDI.

83. In this environment of uneven trade preferences, the need to improve external competitiveness through domestic measures is heightened. Comparison with other CEECs suggests that Croatia does have room for further productivity gains. Such benefits could be achieved through an acceleration of Croatia’s structural reform program, including the privatization of key enterprises in a manner that improves internal decision making, wage discipline, and overall efficiency.

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