Republic of Croatia: Request for Stand-By Arrangement
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International Monetary Fund
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Publication Date:
11 Feb 2003
eISBN:
9781451817287
Language:
English
Keywords:
ISCR; CR; twelve-month rate; headline inflation; core inflation; privatization receipt; core rate of inflation; current account; broad money; foreign currency; short-term debt; retail price
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This paper examines the Croatia’s Request for a Stand-By Arrangement (SBA). Despite a disappointing merchandise trade performance, strong exports of services and private transfers have helped restrain the current account deficit. The authorities' program for 2003 constitutes a major step toward long-term fiscal sustainability and higher economic growth. The authorities recognize that more needs to be done in the future to boost the population’s standard of living and put Croatia on a firm path of real convergence with the European Union. The IMF staff supports the authorities’ request for a SBA.

Abstract

This paper examines the Croatia’s Request for a Stand-By Arrangement (SBA). Despite a disappointing merchandise trade performance, strong exports of services and private transfers have helped restrain the current account deficit. The authorities' program for 2003 constitutes a major step toward long-term fiscal sustainability and higher economic growth. The authorities recognize that more needs to be done in the future to boost the population’s standard of living and put Croatia on a firm path of real convergence with the European Union. The IMF staff supports the authorities’ request for a SBA.

I. Recent Economic Developments and Near-Term Outlook1

1. Buoyant domestic demand continues to bolster economic activity. After reaching 3.8 percent in 2001, real GDP growth accelerated to 4.1 percent in the first half of 2002, underpinned by strong household consumption and business and government investment.2 High-frequency indicators show that activity continued to be strong in the third quarter, with year-on-year growth of 8.1 percent for industrial production and 15.9 percent for retail sales volume (Figure 1). Even if consumption and investment decelerated as expected in the last quarter, the staff projects growth of at least 4 percent in 2002 (text table). After the strong increase in consumer credit in 2002 (see paragraph 4), growing household indebtedness should moderate the growth of private consumption in 2003. However, real GDP growth is expected to accelerate further to 4.2 percent on the back of stronger external demand and continuing support from private and government investment.

Figure 1.
Figure 1.

Croatia: Real Sector Developments, 1996-2002

Citation: IMF Staff Country Reports 2003, 027; 10.5089/9781451817287.002.A001

Source: Croatian Bureau of Statistics.

Main Economic Indicators

(In percent, unless otherwise indicated

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Sources: Croatian National Bank, Ministry of Finance, Central Statistics Bureau, and staff estimates.

2. Despite a disappointing merchandise trade performance, strong exports of services and private transfers have helped restrain the current account deficit. While merchandise exports have been affected by a weak external environment and lack of structural change,3 the tourist season was good, with an annual increase in real turnover estimated at around 5 percent. As a result, despite a strong increase in imports, the current account deficit is likely to narrow from 3.8 percent of GDP in 2001 to 3.6 percent of GDP in 2002. Exports of services (transportation and tourism) and income transfers from abroad have increased significantly in recent years thanks to improved economic and political stability in the region. With the further upgrading of hotels and recreational infrastructure, these trends are likely to continue. Import growth is expected to slow in 2003 as machinery and equipment for highway construction have already been procured, car purchases decline, and imports to stock the new supermarkets wind down. If the recovery in Europe will materialize as expected, the current account deficit should remain broadly unchanged in 2003.

3. Inflationary pressures remain subdued. Despite a recent increase in electricity prices, retail price inflation remains low, with annual rates of 2 percent for headline inflation and 1 percent for core inflation in November (Figure 2). On average, headline inflation is likely to have fallen from 4.9 percent in 2001 to 2.4 percent in 2002. However, after two years of continuous declines facilitated by wage restraint, import tariff reductions, and increased competition in retail trade, the return of positive producer price inflation after mid-year suggests that retail price inflation may have reached a bottom and be about to rise to a slightly higher level, reflecting lower productivity growth in the nontradable sector in the context of broad exchange rate stability (Balassa-Samuelson effects).4 Staff and authorities estimate this level to be around 3-3½ percent on average.

Figure 2.
Figure 2.

Croatia: Retail Price inflation, 1996-2002

(Annual percent change)

Citation: IMF Staff Country Reports 2003, 027; 10.5089/9781451817287.002.A001

Sources: Croatian National Bureau of Statistics; and Croatian National Bank.1/ Excludes energy and administrative prices.

4. While monetary conditions are stabilizing, credit to the private sector continues to expand rapidly. With the exception of a temporary weakenings in July (due to large external debt repayments) and October (for seasonal reasons), the currency has been broadly stable and the CNB has intervened mostly to stem its appreciation (Figure 3). The kuna has remained rather stable against the euro, while appreciating by 12 percent against the dollar, and competitiveness—as measured by the CPI-based real effective exchange rate—has deteriorated by less than one percent. The growth of broad money has slowed considerably, and its twelve month rate of increase is expected to decline sharply in coming months due to base-year effects.5 Liquidity in the banking system remains high, and money market interest rates currently hover at around 1½ percent. The strong growth of bank credit to the private sector—credit to households increased by 36 percent year on year in September, as opposed to 22 percent for enterprises—has not yet shown any signs of abating (Figure 4). However, there is no evidence yet that banks’ loan portfolio has deteriorated as a consequence. Indeed, the share of nonperforming loans is declining and indicators of solvency and profitability continue to improve.6.

Figure 3.
Figure 3.

Croatia: Exchange Rates Development, 1994-2002

Citation: IMF Staff Country Reports 2003, 027; 10.5089/9781451817287.002.A001

Sources: Croatian National Bank; and IMF Information Notice System.
Figure 4.
Figure 4.

Croatia: Money and Bank Credit, 2000-2002

(Annual percentage changes)

Citation: IMF Staff Country Reports 2003, 027; 10.5089/9781451817287.002.A001

Source: Croatian National Bank.

5. Further progress has been made on fiscal consolidation. Notwithstanding stepped-up highway and housing construction, the general government deficit is expected to decline from 6.8 percent of GDP in 2001 to 6.2 percent of GDP in 2002. Expenditure overruns are projected on wages due to delays in defense sector layoffs and higher year-end bonuses and on goods and other services in the health sector. However, a better-than-expected revenue performance (from profit tax, personal income tax, and customs duties), savings on interest payments, and lower-than-planned capital spending—due to technical difficulties in implementing the ambitious original plan by the highway construction agency (HAC)—will more than offset these slippages. The deficit could be even lower if the fourth-quarter acceleration of highway construction falls short of expectations. Despite the reduction of the deficit, however, general government debt (including guarantees) is projected to rise from 55 percent of GDP at end-2001 to 57½ percent at end-2002, mainly due to the extension of government guarantees.

II. The Authorities’ Strategy and Program for 2003

6. The aim of the new program is to make progress toward long-term fiscal sustainability and strengthen the prospects for sustained high rates of growth. The authorities realize that further progress will be needed after 2003 to achieve these goals.7 But they view their program as a continuation of their medium-term efforts at fiscal consolidation and structural reform in a difficult pre-electoral period. In view of the strong external position, the authorities do not need the support of the Fund’s financial resources, but they are convinced that the discipline of a Fund-supported program and the increased financial market confidence that would accompany it would help them achieve their objectives. Therefore, the proposed access is low and the authorities plan to treat the arrangement as precautionary.

7. The program seeks a further acceleration of economic growth to some 4¼ percent. Notwithstanding some fiscal withdrawal, the slight acceleration of growth would result from an improvement in external conditions, confidence effects, and the cumulative impact of structural reforms. The principal contribution would come from net exports and private domestic demand. Most of the impulse provided by the highway construction program will occur in the first half of 2003 (Tables 1–2).

Table 1.

Croatia: Key Macroeconomic Indicators, 1999-2003

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Sources: Croatian National Bank, World Economic Outlook, and Fund staff estimates.

In 2000, includes 0.5 percent of GDP in back taxes.

Gross reserves adjusted downward by foreign currency redeposit requirements held at the CNB, and by the amount of outstanding foreign currency CNB bills.

On a remaining maturity basis. Coverage is limited to short-term debt contracts registered with the CNB.

October. A change in methodology has introduced a break in the series as of January 2002.

Table 2.

Croatia: GDP by Expenditure Category, 2000-2003

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Sources: Croatian National Bank, Ministry of Finance, Central Statistics Bureau and staff estimates.

Includes public enterprises.

Includes statistical discrepancy.

8. Inflation is targeted to remain below 3½ percent. In the absence of severe external shocks or large increases in administered prices, the CNB is confident that inflation will remain below 3.5 percent. A lower objective would not be achievable with exchange rate stability in the presence of significant Balassa-Samuelson effects.8 With goods prices virtually stable and producer prices falling until mid-2002, retail price inflation is mainly attributable to higher services prices, which have been rising at an annual rate of 5-10 percent. The program assumes an average retail price inflation of 3 percent (3.3 percent as measured by the GDP deflator) to accommodate price increases in sectors with less rapid productivity increases. In line with its primary policy objective of price stability, the CNB stands ready to tighten monetary policy if the inflation objective is threatened.

9. The CNB intends to keep the reserve cover at over 5 months of imports. Assuming a recovery in Western Europe and a stable security situation in South-Eastern Europe, the current account deficit should remain close to 314 percent of GDP. Structural measures to attract greenfield investment, privatization, and continued trade integration should ensure direct investment inflows that, as in recent years, exceed the projected current account deficit and allow both a decline in the external debt ratio and the reserve gain necessary to attain the programmed reserve cover ratio (Table 4).

Table 3.

Croatia: Saving-Investment Balances, 1999-2007

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Sources: Croatian National Bank, Ministry of Finance, Central Statistics Bureau, and staff estimates.

Current revenues minus current expenditures (excluding current transfers and interest payments).

Excludes net lending.

Includes public enterprises.

Includes change in inventories.

The introduction of the second pillar of the pension system is expected to reduce government saving (and correspondingly increase non-government saving) by 1 percent of GDP in 2002 and 1.3 percent of GDP in 2003.

Table 4.

Croatia: Balance of Payments, 1998-2003

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: Croatian National Bank, World Economic Outlook, and staff estimates.

Data for short term commercial bank credits derived from the CNB foreign exchange department.

Coverage only includes import Trade credits with maturities less than three months.

Gross reserves adjusted downward by foreign currency redeposit requirements held at the CNB, and by the amount of outstanding foreign currency CNB bills.

Coverage is limited to short term debt contracts registered with the CNB.

Short-term debt is presented on a remaining maturity basis.

A. Fiscal Policy

10. The principal aim of the 2003 fiscal program is to stabilize the general government debt ratio.9 After uninterrupted increases since independence in 1991 and a jump of 25 percentage points during 1997–2002 (Figure 5), debt ratio stabilization would represent a major achievement. To this end, the recently adopted 2003 budget envisages a further reduction of the general government deficit from an expected 6.2 percent of GDP in 2002 to 5 percent of GDP in 2003. With a conservatively estimated amount of privatization receipts and no further increase in government guarantees, a deficit of this size would stabilize the debt ratio at its estimated end-2002 level of 57½of GDP. Given the impact on the 2003 budget of exceptional factors—notably the highway construction program, which accounts for a net deficit of 1.9 percent of GDP—and the revenue loss from introducing the second pension pillar, which is expected to reach 1.3 percent of GDP, a fiscal deficit of 5 percent of GDP is an ambitious target (text table).

Figure 5.
Figure 5.

Croatia: Public Debt Stock, 1997-2002

Citation: IMF Staff Country Reports 2003, 027; 10.5089/9781451817287.002.A001

Sources: Ministry of Finance; and staff estimates.

Fiscal Adjustment Program

(In percent of GDP)

article image
Sources: Ministry of Finance and staff estimates.

11. As the revenue ratio is budgeted to decline, the deficit reduction would be achieved by an even larger reduction of the expenditure ratio.

  • The revenue ratio is expected to decline from 45.4 percent of GDP in 2002 to 45 percent of GDP in 2003 (Tables 5–6). Revenue losses would come from the full-year effect of introducing the second pension pillar in 2002, an increase in the standard personal income tax deduction, an exemption from the real estate transaction tax for first-time home buyers, a small reduction of social security contributions, and ongoing import tariff reductions under international agreements. These losses would outweigh expected gains coming from the extension of the base of social security contribution collections to virtually all types of labor income, the reduction of personal income tax deductions for residents of designated special areas, the introduction of an additional car insurance tax, and the full-year effect of supplementary health insurance introduced in mid-2002 (MEFP, paragraph 8).

  • The expenditure ratio is expected to decline from 51.5 percent of GDP in 2002 to 50 percent of GDP in 2003. Restraint on spending for wages (-0.6 percentage points of GDP with respect to 2002), goods and non-wage services (-0.9 percentage points of GDP), and subsidies and other current transfers (-0.4 percentage points of GDP) would more than account for the expected expenditure ratio reduction and make room for increases in capital spending and interest payments (MEFP, paragraph 9).

Table 5:

Croatia: Consolidated General Government Fiscal Operations by Economic Category on an Accrual Basis, 1999-2003 1/

(In percent of GDP)

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Sources: Ministry of Finance and staff estimates.

Includes the 53 largest local governments.

In 2000, includes 0.5 percent of GDP in back taxes.

In 2003, includes 0.5 percent of GDP in bridge loan.

Table 6:

Croatia - Consolidated General Government Fiscal Operations by Economic Category on an Accrual Basis, 2003

(Hrk million)

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Sources: Ministry of Finance and staff estimates.

In 2003, includes 0.5 percent of GDP in bridge loan.

12. To achieve its fiscal adjustment objectives, the program relies heavily on a tight wage policy in the government sector. The main elements of the measures to restrain wage payments in the government sector are described in paragraph 9 of the MEFP. The budget limits the increase in the nominal wage bill of the general government to only 1 percent in 2003. Although still significantly higher than in most other central and eastern European countries, the wage bill to GDP ratio would decline from 11.1 percent in 2002 to 10.5 percent in 2003. This result is to be achieved through a general wage freeze and the implementation of the recently adopted defense sector reform legislation, which envisages a reduction of employment by 12,000 in the first nine months of 2003.10 Increases with respect to 2002 are limited to ad hoc adjustments for primary and secondary schoolteachers (0.1 percent of GDP) and a vacation bonus (0.1 percent of GDP). 11 Nominal reductions of some other bonuses and allowances for central government workers would also help contain the total wage bill. The authorities will consult with the Fund on appropriate measures to safeguard their fiscal deficit target if the cumulative quarterly wage bill of the central government exceeds the indicative limits specified in Annex III of the MEFP.

13. Deficit financing relies less on privatization and foreign borrowing and more on domestic financing than in the past. Privatization is budgeted conservatively to yield only 1.2 percent of GDP (MEFP, paragraph 10), with more than two thirds expected from the oil (INA) and telecommunication (HT) companies. To buttress the debt ratio reduction objective, an asymmetric adjustor calls for offsetting expenditure cuts in the case of underperformance, and debt reduction in the case of overperformance, with respect to the privatization target. In contrast to the past and the government’s original borrowing plans for 2003, net borrowing, equivalent to 3.8 percent of GDP, will rely mainly on the domestic capital market. The authorities agreed to the staff’s proposal as this change would ease the appreciation pressure on the exchange rate and provide financial assets to private pension funds collecting second-pillar contributions. This borrowing is to be carefully coordinated with the CNB, whose monetary program envisages bank financing for the government of 1.3 percent of GDP. The remaining gross foreign borrowing requirement is less than half its estimated 2002 level, given the absence of bullet bond repayments in 2003. In addition, a brief delay in privatization receipts will require the contracting of a short-term bridge loan of 0.5 percent of GDP. The Ministry of Finance will arrange all foreign borrowing by the general government.

B. Monetary and Exchange Rate Policy

14. The monetary program for 2003 aims at maintaining inflation at less than 3½ percent on average. Even though the new CNB law clearly identifies price stability as its main policy objective, the CNB considers that conditions are not appropriate for formal inflation targeting and intends to continue to pursue its mandate by maintaining the exchange rate of the kuna broadly stable vis-à-vis the euro.12 In the CNB’s view, balance of payments trends and competitiveness indicators suggest that the present level of the exchange rate is broadly appropriate.13 If anything, market forces are pushing the exchange rate toward appreciation, and the CNB indicated that it will not resist prolonged appreciation pressures if its inflation objective is jeopardized or if its target for purchases of foreign exchange were to be exceeded. Responding to the staff’ concern about one-way bets and unhedged foreign exchange exposure, the CNB is committed to allow some exchange rate variability under the program.

15. Fiscal adjustment, reduced government reliance on foreign borrowing, and the new foreign exchange law will greatly facilitate the conduct of monetary policy under the program. Large foreign currency inflows due to government external borrowing have contributed to appreciation pressure and monetary instability in the past. The government’s contribution to these inflows will be substantially reduced under the program, leaving room for the issuance of government debt in the domestic financial market, some of which will be denominated in kuna. In addition, the CNB stands ready to use the room for a more active monetary policy that will result from the power to introduce temporary exchange controls on short-term capital inflows under the new foreign exchange law.

16. The growth of monetary and credit aggregates is expected to decelerate under the program. The twelve-month rate of broad money growth is forecast to rise slightly to 14½ percent at end-2003. This rate of increase is not out of line with monetary expansion before the recent surge associated with euro conversion (Table 7). Taking into account Croatia’s relatively high per capita income, the rate of monetization is not excessive and the projected monetary growth should be absorbed without inflationary or balance of payments pressures. Should credit growth fail to slow down, the CNB will consider the introduction of higher provisioning requirements on banks with rapidly expanding loan portfolios. The CNB does not see any room to ease reserve requirements in 2003, and it stands ready to resist further reductions of market interest rates. If base money growth turns out stronger than programmed, the CNB will consult with the Fund to determine whether the inflation outlook is consistent with the limits on net domestic assets (MEFP, paragraph 15).

Table 7.

Croatia - Monetary Accounts, 2000-2003

(End-period; in millions of kuna unless otherwise stated)

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Source: Croatian National Bank and staff projections.

Blocked and restricted deposits, excluding required reserves in foreign currency.

The kuna/dollar program quarterly exchange rates (period average) are 7.63 (March), 7.62 (June), 7.61 (September), and 7.78 (December).

C. Structural Reforms

17. Because of their importance for sustainable high growth, structural reforms will be crucial elements of the program. The government intends to implement major reforms in many areas in 2003.

  • In the fiscal area, the authorities fully recognize the need to improve fiscal transparency and strengthen debt management. Although four new central spending units were created under the 2003 budget,14 all of them have been included in the 2003 budget, together with the funds for employment and growth and for regional development. The authorities view these funds and agencies as necessary to implement their government program and international commitments (e.g., under the EU Stabilization and Association Agreement). Their transparent incorporation into the state budget should ensure the timely compilation of fiscal information. No new funds or agencies will be created during 2003 (MEFP, paragraph 17). With a view to ensuring the stabilization of the general government debt ratio and slowing the expansion of bank credit, the Ministry of Finance will issue new guarantees only to the extent that existing guarantees are amortized or expire (MEFP, paragraph 12). By end-March 2003, criteria for issuing guarantees—in particular, subjecting them to the 60 percent of GDP limit for general government debt—will be adopted (structural performance criterion; MEFP, paragraph 16). To improve the capacity of the Ministry of Finance to conduct debt management and report comprehensive and reliable statistics for the general government in a timely manner, the ministry will hire appropriately qualified staff, reorganize its operation, and request technical assistance during 2003 (MEFP, paragraph 18). The ministry, the CNB, and the Croatian Bureau of Statistics (CBS) will form a task force to reconcile statistics on general government operations.

  • In the financial sector, the authorities are further strengthening the legislative framework. A new foreign exchange law is expected to be approved by parliament in January 2003. Seven bylaws to implement the new banking law will be issued by end-2002. New regulations on the calculation of the net open foreign exchange position of banks for prudential purposes will be issued by end-June 2003 and implemented by end-September 2003 (structural benchmarks; MEFP, paragraph 20).

  • The government is determined to accelerate privatization and restructuring of the oil (INA) and power (HEP) companies (MEFP, paragraph 22) and of the companies owned by the privatization fund, the deposit insurance agency, and the pension fund (MEFP, paragraph 21). These measures would enhance the medium-term growth potential of the economy. The postal bank (HPB) will acquire Croatia Banka, which could not be privatized, and then be privatized. The adoption of a privatization plan for HPB to end the government’s majority ownership has been made a structural benchmark (MEFP, paragraph 23).

  • To enhance the functioning of markets and stimulate employment growth, the government is preparing new company, competition, bankruptcy, and labor laws for parliamentary adoption by early 2003 (MEFP, paragraph 24). Judicial reform will support these same objectives (MEFP, paragraph 25).

  • Trade liberalization will continue. An agreement to join CEFTA will take effect on March 1, 2003. A free trade agreement with Yugoslavia is expected to be signed soon. Other free trade agreements are being negotiated with Estonia, Latvia, and Moldova (MEFP, paragraph 26). Although more than 80 percent of foreign trade is now conducted under free trade agreements, Croatia’s exports to the EU continue to be hampered by the non-application of the Pan European Rules of Cumulation of Origin.

D. Risks to the Program and External Financing

18. The risks to the program relate mainly to the external environment and slippages in program implementation.

  • Tourism receipts are very sensitive to regional stability and various other factors outside the control of the authorities (weather, environmental and terrorism scares, economic conditions in countries of origin). Some of these (fear or air travel, environmental pollution or bad weather in competing tourist destinations) might actually boost tourism inflows. However, a one-percent drop in tourism receipts would increase the current account deficit by 0.2 percent of GDP. More than 50 percent of Croatia’s merchandise exports are to the EU. A one-percent drop in growth in advanced partner countries in Europe would raise the current account deficit by 0.6 percent of GDP. Although it produces small amounts of hydrocarbons and exports refined oil products to neighboring countries, Croatia is a net importer of crude petroleum. A US$ 1 increase in the price of oil would raise the current account deficit by 0.1 percent of GDP. As growth and oil price assumptions of the winter WEO were used for the program, the likelihood that some of these risks will materialize has grown.

  • The main risks to the fiscal deficit target attach to wage policy and the strict implementation of the employment reduction planned in the defense sector, which are politically difficult. However, the government is prepared to implement corrective measures, in consultation with the Fund, if the central government wage bill exceeds its cumulative quarterly limits.

  • Risks of overheating and asset bubbles are small. There still is substantial unemployment (15.2 percent, based on survey data) and prices of financial assets and real estate have not increased much despite capital inflows and monetary ease.

19. Standard sustain ability analysis shows that most isolated shocks do not destabilize the general government and external debt ratios (Appendix V). Some risks attach to the baselines, which assume a continuation of high growth and low interest rates. However, the government debt ratio resumes its decline even after a combined shock. By contrast, the external debt ratio is more vulnerable to isolated shocks (and, of course, their combination): it exhibits sustained increases in response to shocks to the Croatian U.S. dollar GDP deflator or the current account. Its vulnerability to shortfalls in privatization receipts is small: the debt ratio would be 2.4 percentage points higher in 2005 if none of the receipts projected for 2003–05 were forthcoming, and no further privatizations are projected after 2005.

20. Croatia is likely to meet its external financing requirements in 2003 and beyond. Partly due to the absence of bullet loan repayments, the gross financing requirement (including the programmed accumulation of international reserves) is expected to decline by almost 30 percent in 2003, before gradually increasing again during 2004–07 (Table 8). In light of the most recent vulnerability indicators, prospective market access would not seem to be a problem in meeting the reduced financing requirements of both the government and private sectors in 2003 (Table 9). The government intends to meet most of its external borrowing needs early in 2003 by issuing a eurobond of € 500 million, while borrowing the balance around midyear in the Japanese market. The short-term bridge loan mentioned in paragraph 13 above is expected to be repaid in the second quarter with proceeds from the privatization of INA. As indicated in paragraph 10 of the MEFP, the government intends to cut expenditure if privatization receipts were to fall short of the budgeted amount.

Table 8.

Croatia: External Financing Requirements, 2001–2007

(In millions of U.S. dollars)

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Source: Croatian Central Batik, WEO, and Fund staff estimates and projections.

Includes General Government and HBOR.

Excluding the IMF.

Short-term loans and trade credits with original maturity less than one year.

Includes all other flows and errors and omissions.

Table 9.

Croatia: Indicators of External and Financial Vulnerability, 1998-2002

(In percent, unless otherwise indicated)

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Sources: Croatian National Bank; Ministry of Finance; Central Bureau of Statistics; Bloomberg; MediaScan; and IMF staff estimates.

An increase in the index reflects a depreciation; end-year figures indicated annual average.

In January 2000, a new methodology, in line with European standards, for processing data on imports and exports was adopted. The new presentation uses the date when the declaration was cleared rather than the date when the declaration was received.

Quarterly figures may be affected by the quarterly annualized GDP.

Data for short-term commercial bank credits derived from the CNB Foreign Exchange Department.

Coverage limited to short-term debt contracts registered with the CNB.

Short-term debt is presented on a remaining maturity basis.

Gross reserves adjusted downward by foreign currency redeposit requirements held at the CNB, and by the amount of outstanding foreign currency CNB bills.

Does not include debt that was excluded from the London Club agreement.

Using the average change rate for the period, annualized for quarters.

The 35-day CNB bill yield deflated by the annual percentage change in the retail prices.

III. Design of the Proposed Stand-By Arrangement

A. Modalities of the Arrangement

21. The arrangement is proposed to be for the 14 months ending in early April 2004, allowing purchases related to performance under a one-year program period for calendar year 2003. Test dates are set at the end of each quarter. Under the arrangement, the requested amount of SDR 105.88 million (29 percent of quota) will be made available in five purchases. Due to the early repurchase of the entire amount of Fund credit outstanding, immediate access of more than 25 percent of quota will be necessary to allow upper credit tranche conditionality and quarterly phasing. The first purchase, equivalent to SDR 91.276 million (a little more than 25 percent of quota) will be available on approval. The other purchases, all of equal amount (1 percent of quota), will be available after each of the four quarterly test dates according to the schedule provided in Table 10. In view of the comfortable reserve level, easy access to capital markets, and the positive external outlook, the authorities intend to treat the arrangement as precautionary and do not plan to make any purchases.

Table 10.

Croatia: Schedule of Purchases Under the Proposed Stand-By Arrangement

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Assuming maximum proposed access. The authorities plan to treat the arrangement as precautionary and do not intend to make any purchases.

B. Program Monitoring

22. The authorities have proposed the implementation of prior actions for staff to support the recommendation of Board approval of the stand-by arrangement (MEFP, Annex II). As of January 14, 2003, substantial progress had been made toward the timely completion of the proposed prior actions (Table 11). All prior actions are expected to be completed prior to Board consideration of the authorities’ request.

Table 11.

Croatia: Status of Prior Actions as of January 14, 2003

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Source: Croatian Authorities.

23. The monitoring of the program will be based on the following quantitative performance criteria (MEFP, Annexes III-VIII): (i) a quarterly limit on the cumulative change of the deficit of the consolidated central or general government, respectively;15 (ii) a quarterly limit on the cumulative change of the stock of central government arrears;16(iii) a quarterly limit on the cumulative change in the contracting or guaranteeing by the public sector of non-concessional external debt with an original maturity of over one year, with a sublimit on such debt with an original maturity of more than one and less than five years; (iv) a quarterly limit on the cumulative net change of the stock of short-term external public and publicly guaranteed debt; (v) a quarterly limit on the cumulative change in the net usable international reserves of the CNB; and (vi) a quarterly limit on the cumulative change in the net domestic assets of the CNB.17 Continuous performance criteria cover: (i) the non-accumulation of new external payments arrears by the Republic of Croatia; and (ii) the imposition or intensification of restrictions on the making of payments and transfers for current international transactions, the introduction or modification of multiple currency practices, the conclusion of bilateral payments agreements that are inconsistent with Article VIII, and the imposition or intensification of import restrictions for balance of payments reasons.

24. Structural conditionality will be limited to one performance criterion and five benchmarks.

  • The performance criterion relates to the preparation of new guidelines for issuing government guarantees that subject such guarantees to the 60 percent of GDP limit on the general government debt ratio by end-March 2003, a measure that has become more urgent after their recent rapid increase and that is needed to ensure stabilizing the debt ratio.

With regard to structural benchmarks,

  • The preparation of a privatization plan by end-March 2003 for the new bank resulting from the acquisition of Croatia Banka by HPB is crucial to avoid the repetition of quasi-fiscal operations and to signal the government’s determination to get out of commercial banking.

  • Although a three-year fiscal framework was prepared along with the 2003 budget and the staff is assisting the authorities to improve fiscal reporting on a general government basis, adoption of legislation by end-March 2003 that enshrines these requirements is considered important for fiscal transparency and accountability.

  • Given the experience with a recent run on the third largest bank18 and the importance of a stable banking system in the highly euroized economy, issuance and implementation of a regulation requiring the inclusion of options in the calculation of banks’ net open foreign exchange position are made structural benchmarks for end-June and end-September 2003, respectively.

  • Adoption of a decision on the partial privatization of INA by end-March 2003 is important for the program’s debt ratio stabilization objective.

25. Two reviews are scheduled under the arrangement, before the second and fourth purchases. Both reviews would focus on progress in implementing structural reforms and wage and employment policy in the government sector. During the first review, the quantitative performance criteria for the second half of 2003 would also be established.

C. Capacity to Repay the Fund and Safeguards Assessment

26. Should a need emerge to draw on the resources made available under the arrangement, the staff is confident that Croatia can meet its financial obligations to the Fund. Under the proposed purchase schedule, Fund credit outstanding would peak at SDR 105.88 million (2.6 percent of gross usable international reserves), while debt service to the Fund would not exceed 0.5 percent of exports of goods and nonfactor services during the entire repayment period (Tables 12 and 13).

Table 12.

Croatia: Projected Payments to the Fund as of November 30, 2002 Under Obligations Repurchase Schedule

(In millions of SDRs)

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Source: IMF Treasurer’s Department.

The GRA basic rate of charge 2.85 percent is computed by applying a factor of 1.2800 to the SDR interest rate 2.23 percent. It is then increased by 0.02 percent for burden sharnt and furthermore by 0.08 percent for the SCA for a total rate of 2.95 percent.

Table 13.

Croatia: Indicators of Capacity to Repay the fund, 2002-2010

(Under Obligations Schedule)

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Source: Croatian National Bank; WEO; and staff estimates.

As of August 31, 2002

Including the hypothetical purchases under the proposed precautionary stand-by arrangement, not shown in balance of payments projections (Table 4).

For the projection period: WEO assumptions of August 2002

27. A full safeguards assessment of the CNB has been completed. The conclusions indicate that the safeguards in place at the CNB appear generally adequate, but certain weaknesses were identified in the internal audit and control areas. The safeguards assessment recommended the following principal measures: (i) strengthening of the internal audit function by enhancing the skills of the Internal Audit Department staff, (ii) extending coverage of internal audit to higher-risk areas of the CNB’s operations, and (iii) establishing control procedures for the reconciliatoin of data reported to the Fund. The authorities have committed to the implementation of these and other recommendations, which will be monitored by staff in the context of program reviews.

IV. Staff Appraisal

28. The authorities are to be commended for adopting a program in a pre-electoral period that remains faithful to their fiscal consolidation and structural reform strategy. Much has been achieved in the first three years of the government’s term in office. The general government deficit and expenditure ratios have been lowered and progress has been made in restructuring and privatizing the economy, especially in the banking sector. However, the public debt ratio has continued to climb, the labor market remains inflexible, and several large public enterprises are a drag on the economy. Against this backdrop, the authorities’ program promises further substantial progress, although this will have to be followed by further adjustment and reform efforts in future years.

29. With debt ratio stabilization as the lynchpin of the macroeconomic program, the authorities should not spare any effort to reduce the fiscal deficit to the proposed level, realize their privatization objective, and limit the extension of guarantees. A fiscal adjustment of 1.2 percentage points of GDP despite a declining revenue ratio and an ambitious investment program represents a substantial effort. It requires, in particular, the firm implementation of the adopted wage policy and of the plans to reduce employment in the defense sector. The budget has no room for accommodating slippages in these areas without necessitating major cutbacks in investment spending. The government should strictly adhere to its privatization plans and use excess privatization receipts for debt reduction. At the same time, the planned new criteria for extending guarantees should be applied restrictively in 2003 so as to prevent any further increase in guarantees outstanding and contribute to the slowdown in credit expansion.

30. The shift from external to domestic borrowing to finance the fiscal deficit is welcome. The domestic market remains very liquid and interest rates are low. The government should strive to borrow in domestic currency to lower its vulnerability to exchange rate fluctuations. Doing so without the customary indexation clauses should have become easier after several years of experience with, and in light of continued favorable prospects for, low inflation and exchange rate stability. Government borrowing in the domestic market must be closely coordinated with the CNB. It will facilitate the CNB’s task by reducing currency appreciation pressure and promote the development of the domestic capital market.

31. The CNB’s monetary program aims at an orderly deceleration of monetary and credit aggregates. After the extraordinary growth triggered by the euro conversion, monetary aggregates are already slowing down. However, bank credit is still expanding at a speed that, if sustained, is not compatible with the program’s inflation and external current account targets and raises concerns about the prudential implications of such an expansion. Although aggregate financial indicators give no reason for alarm, the CNB appropriately relies on its supervisory powers to ensure that banks’ lending decisions remain sound and it should not hesitate to make good on its intentions to raise provisioning requirements if credit expansion does not slow down as expected. Banks should be cautioned about risks stemming from lending in, or indexed to, foreign exchange to unhedged borrowers.

32. The CNB’s exchange rate policy remains broadly appropriate. External current account and real effective exchange rate trends do not suggest that the level of the exchange rate has ceased to be adequate. Improvements in competitiveness should therefore be sought through structural reforms, wage restraint, and improved market access. The maintenance of a broadly stable exchange rate has served the economy well, but the CNB is right to warn economic agents against unhedged foreign exchange exposure. It should also allow greater exchange rate variability so as to discourage one-way bets.

33. While helpful in the program context, the structural reform measures will mainly serve to improve the medium-term prospects of the economy. Measures to produce timely, high-quality fiscal data are an urgent priority to monitor the present program and enhance fiscal transparency. A fiscal ROSC should point the way for further improvements in the medium term. The new foreign exchange law should facilitate the conduct of a more active interest rate policy, while the implementation of the bylaws to the banking law and the inclusion of options in banks’ net open foreign exchange position should further improve bank efficiency and financial soundness as well as strengthen banking supervision. The government should press ahead with its privatization and restructuring plans and withdraw from commercial banking and most other productive activities. Finally, new company, competition, bankruptcy and labor laws as well as judicial reform should exert strong positive effects on growth and employment in the medium term.

34. In the given circumstances, the authorities’ program for 2003 constitutes a major step toward long-term fiscal sustain ability and higher economic growth that deserves the support of the Fund. The authorities recognize that more needs to be done in the future to boost the population’s standard of living and put Croatia on a firm path of real convergence with the EU. The present program does not only prevent any backsliding in the difficult pre-electoral period, it also makes substantial progress in laying the foundations for pursuing this ambitious longer-term agenda. For this reason, the staff supports the authorities’ request for a stand-by arrangement.

APPENDIX I Croatia—Fund Relations

(As of November 30, 2002)

I. Membership Status: Joined 12/14/92; Article VIII.

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans:

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V. Financial Arrangements:

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VI. Projected Obligations to Fund (SDR million; based on existing use of resources and present holdings of SDRs):

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On December 27, 2002 Croatia made an early repurchase in respect of the entire amount of Fund credit outstanding.

VII. Safeguards Assessment:

Under the Fund’s safeguards assessment policy, the Croatian National Bank (CNB) is subject to an assessment with respect to the requested arrangement. A full safeguards assessment of the CNB was completed on January 3, 2003. The assessment concluded that safeguards in place at the CNB appear generally adequate. However, certain weaknesses were identified in the internal audit and control systems, and the safeguards assessment recommends corrective actions to address them.

VIII. Exchange Rate Arrangement:

In December 1991, Croatia left the Yugoslav dinar area and adopted the Croatian dinar as sole legal tender. The Croatian dinar was replaced by the Croatian kuna on May 30, 1994. The exchange rate of the kuna is determined by supply and demand in the interbank market, with occasional participation of the Croatian National Bank. The authorities’ exchange rate policy regarding the Croatian kuna is accordingly classified as “managed floating with no pre-announced path for the exchange rate”. The Croatian National Bank transacts only in euros, U.S. dollars, and SDRs. On November 30, 2002, the official exchange rate was kuna 7.4828 per U.S. dollar (middle rate).

IX. Exchange Restrictions:

Croatia has accepted the obligations of Article VIII and maintains an exchange system that is free of restrictions on payments and transfers for current international transactions except for a residual balance of foreign currency deposits frozen in 1991 that may include proceeds from current international transactions. This restriction was given temporary approval at EBM/02/84.

X. Article IV Consultation and Recent Use of Fund Resources:

The last Article IV consultation with Croatia was concluded on August 5, 2002 (IMF Country Reports 02/178, 02/179 and 02/180). Executive Directors commended Croatia’s strong economic performance but expressed concern about the still high fiscal deficit, the rising public debt ratio, and delays in structural reforms. With the approval of the requested stand-by arrangement, Croatia will be automatically placed on the 24-month consultation cycle, subject to the provisions of the decision on consultation cycles (Decision No. 12794-(02/76), adopted July 15, 2002).

A 14-month stand-by arrangement for an amount equivalent to SDR 200 million (55 percent of quota) expired on May 18, 2002. Performance under the program was mixed. While its macroeconomic objectives were generally exceeded and most quantitative performance criteria were observed, slippages occurred with respect to structural performance criteria and benchmarks. No purchases were made under the arrangement, which was treated as precautionary by the authorities.

A three-year extended arrangement in an amount equivalent to SDR 353.16 million (135 percent of quota) was approved on March 12, 1997, and a first purchase of SDR 28.78 million was made at that time. The first review was completed on a lapse-of-time basis on October 10, 1997, but the authorities decided not to draw on the resources then made available. Discussions on programs for the second and third arrangement years did not take place and the arrangement expired without further purchases on March 11, 2000.

Discussions in May 1999 failed to reach understandings on a stand-by arrangement to help finance a prospective balance of payments gap in the wake of the Kosovo crisis. The principal areas of disagreement were wage policy—where the staff was asking the authorities to reconsider previously granted government sector wage increases—and privatization policy—where the staff urged the sale of a larger share of state enterprises in order to finance the fiscal cost of resolving a banking crisis.

XI. FSAP Participation:

An FSAP was concluded with the completion of the 2002 Article IV consultation on August 5, 2002 on the basis of missions that took place in April 2001 and September 2001. The FSSA was published (IMF Country Report No. 02/180) and the final FSAP report incorporating the AML/CFT assessment will be forwarded to the authorities shortly.

XII. Technical Assistance 1992–2002:

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XIII. Resident Representative:

Mr. Norregaard took up his post in Zagreb on January 15, 2001.

APPENDIX II Croatia: IMF-World Bank Relations

I. Partnership in Croatia’s Development Strategy

1. The Croatian authorities are determined to maintain macroeconomic stability and attain rapid and sustainable economic growth. To this end, the Government has embarked on reforms to address several key economic challenges, including: (i) reducing macroeconomic imbalances to ensure stability while introducing complementary reforms to address underlying structural causes of fiscal imbalances; (ii) increasing the flexibility of the economy; and (iii) creating a business-friendly environment that is conducive to attracting investment.

2. The IMF has taken the lead in assisting Croatia in maintaining macroeconomic stability. An 18 month stand-by arrangement expired on May 18, 2002. Structural measures in the program were closely coordinated with the World Bank and structural conditionality was limited to areas with significant macroeconomic, typically fiscal, implications. The Government has expressed interest in a successor arrangement to buttress macroeconomic stability in the run up to parliamentary elections that must be held by April 2004.

3. The World Bank has taken the lead in policy dialogue on structural and institutional reforms in a number of sectors. This reform agenda includes measures to: (i) reduce the level of public expenditures and the size of the state; (ii) restructure pension and health sectors; (iii) enhance labor market flexibility; (iv) strengthen market institutions and the competitiveness of the economy; and (v) mitigate the social cost of reforms and poverty through restructuring of social welfare programs. Progress is being made in all of these areas. A US$202 million Structural Adjustment Loan (SAL) was approved by the World Bank Board in December 2001. A Public Expenditure and Institutional Review (PEIR) was completed in March 2002. The PEIR and SAL were key elements of the Bank’s assistance strategy in the 1999 Country Assistance Strategy (CAS). Finally, a Country Economic Memorandum (CEM) is currently being drafted by the Bank following a request by the Government of Croatia to assist in its efforts to join the European Union (EU) down the road.

IMF-World Bank Collaboration in Specific Areas

4. The IMF and World Bank staff maintain a close collaborative relationship in supporting the Government’s structural reforms. In the financial sector, the Bank and the Fund share responsibility and are coordinating their policy advice to the Croatian authorities. A joint FSAP has been conducted. In preparation for the possibility of a new SBA, Bank and Fund staff have agreed on a detailed matrix stipulating areas where each institution will take the lead in supporting key structural measures including several areas of joint responsibility including fiscal transparency and budgetary procedures, public debt management, and reform of the payments system.

5. In most areas of structural reform the Bank has taken the lead, though these areas would be a critical part of the broader economic program which could be supported by a successor SBA.

• Public expenditure management and control

6. Key challenges include: (i) ensuring that recently initiated efforts to create a transparent budget decision making process by consolidating government accounts become broadened to cover all fiscal operations including all off-budget funds and road agencies, as well as local government units; (ii) improving the usefulness, quality, and timeliness of information upon which budget decisions are made; (iii) enhancing financial decision-making by the introduction of an explicit multi-year budgetary framework into the Budget Law, and (iv) strengthening fiscal discipline by increasing penalties for overspending units and introducing transparent criteria for issuing treasury guarantees.

7. The Bank has taken the lead in dialogue on these reforms in the context of the SAL. Implementation on some of these issues has been slower than anticipated. For instance, while the 2002 budget was adopted with a new chart of accounts which includes four extra-budgetary funds and the fiscal activities of the Croatian Bank for Reconstruction and Development, and while it follows modified commitment-based accounting consistent with the methodology of GFS 2001, one extra-budgetary fund and several agencies (Road Agency, Highway Agency, Croatian Privatization Fund and Bank Rehabilitation Agency) were not included in the budget, nor presented as a part of the consolidated budget. In addition, two new funds have been created (the Employment and Development Fund and the Regional Development Fund) and an increasing amount of fiscal spending has been undertaken by the Road and Highway agencies, outside the budgetary framework. Also, an Environment Protection Fund and an Agency for SME Development will start functioning in 2003, with the legislation for their establishment adopted early in 2002. Regarding other issues, the 2002 budget did not adopt penalties for overspending budget units nor set criteria nor a ceiling for government guarantees, as envisaged in the SAL. However, the Government has now drafted a new organic budget law which addresses all of the issues raised in paragraph 6. IMF staff insistence in discussions on a potential successor SBA that such a program must use broader general government data in its quarterly performance criteria has dovetailed in a timely fashion with Bank advice to the authorities.

8. Direct subsidies in Croatia, at some 2.7 percent of GDP in 2001, are in line with other transition countries. But this figure excluded hidden subsidies (custom waivers, social security contribution waivers, tax waivers, credit lines with subsidized interest rates, and debt-equity swaps at nominal value) given to shipyards, agro-conglomerates and other state-owned companies. Together, direct and indirect subsidies have been used to postpone the resolution of non-viable enterprises.

9. However, substantial progress has been made. Under the SAL program the Government has eliminated all indirect subsidies and is drafting a Law on State Aid which will set the types of allowed subsidies in accordance with the WTO guidelines, as well as establish a body to monitor all state aid. Also, at the end of 2001, the Government drafted a subsidies reduction action plan for 2002-2005. In addition, the Government is compiling a registry of farmers to facilitate the provision of income support subsidies. This operation is supported by the Bank through the Farmer Support Services Project. While the latter seems to be on track, direct subsidies in the 2002 budget were not reduced as envisaged in the subsidies reduction action plan. In the context of SAL supervision, the Bank has urged the Government to ensure that subsidies in the 2002 outturn and the 2003 budget are in line with the action plan. This endeavor has been made more difficult following the recent Government decision to bailout the shipyards.

• Pension and health reform

10. The Government’s pension reform aims to reduce the reliance of the pension system on budgetary transfers, while addressing the overall, longer-term problems of coverage, affordability, equity, and adequacy. At the same time, pensions have played an important role in rural poverty alleviation and as a social safety net for the elderly. Although Croatia initiated the design of a comprehensive overhaul of its pension system in the late 1990s, implementation was slow. The reforms included 1998 amendments to the first pillar law which helped control expenditures, protect the minimum pension, and gradually increase the retirement age. These steps were followed in 1999 by legislation providing the framework for mandatory and voluntary funded pensions, managed by private pension funds.

11. The Bank has taken the lead role in supporting pension reform measures under the Pension System Investment Project, as well as the SAL. A multi-pillar pension system was established in January 2002. Implementation has been fully satisfactory. However, further reform challenges remain, including revision of the Pension Insurance Act aimed at strengthening short-term sustainability of the first pension pillar by: (i) increasing actuarial decrement for the early retirement; (ii) reducing the minimum pension accrual rate; and (iii) introducing annual pension indexation. In addition, completion of the legal framework for establishment of pension insurance companies, licensing of voluntary pension funds and development of voluntary pension schemes, as well as improving the Law on Mandatory and Voluntary Pension Funds will create the basis for safe development of the second and third pillars.

12. Croatia spends about 9 percent of its GDP on health, which is well above the levels of CEECs, which average 6-7 percent of GDP. These high levels of health spending are not sustainable. Beleaguered by systemic, sustained and substantial financial deficits in recent years, the health sector has required sizable infusions of funds to stay afloat and maintain the flow of inputs necessary to keep the provision of health services at levels expected by the population. The Ministry of Health has developed and received Parliamentary approval for a Health Sector Reform Strategy in 2001, which is intended to be the basis for overhauling relevant legislation, and reorienting health system practices. In addition, cost-saving measures such as hard budget caps for hospitals and reference pricing for drugs have been introduced by the Ministry of Health in an effort to contain the upward cost spiral.

13. The Bank is supporting a comprehensive program of sector reforms through the Health Reform Project and a program of economic and sector work. A number of structural reform measures, including use of alternative care settings, different primary care models, and improved hospital management practices, are being piloted in Koprivnica with World Bank support. The SAL-supported agenda in the sector includes: reduction of duration of sick leave; revision of co-payment schedules for drugs and selected services; reduction in exemptions from co-payments; and adoption of a methodology for prioritizing health service delivery and input purchases. All of these measures were completed by August 2002. In addition, a centralized regular monthly reporting system of health institutions through the Treasury will be established and will separate costs of basic from the additional health package. Finally, a draft Law on Obligatory Contributions Payment was submitted to Parliament in June 2002. The law will complement the aforementioned measures by: raising the minimum contribution base; unifying, simplifying and broadening the contribution bases; establishing a contribution cap; and improving enforcement responsibilities. However, in the second reading in Parliament exemptions have been extended which will lesson the originally envisaged base broadening.

• Enhancing labor market flexibility

14. As part of the program of reforms supported by the SAL, the new Law on Employment Mediation and Entitlements During Unemployment was adopted by Parliament in March 2002. The law permits the operation of private employment services, and raises the length of employment necessary to qualify for open-ended unemployment benefit by five years, to 35 and 30 years of service for men and women, respectively. This increase will be implemented gradually over five years, by raising the necessary employment record by 6 months every half year.

15. The Government is pursuing discussions within a tripartite working group to introduce changes to the Labor Law. The proposed changes are consistent with those agreed under the SAL. They aim at improving labor market flexibility through reducing the dismissal costs in order to foster hiring and job creation. The most important proposed changes include: (a) relaxing restrictions on the use of fixed-term contracts from 2 to 5 years, (b) easing the pre-conditions for valid dismissals, (c) exempting small firms (employing up to 20 employees) from regulations governing dismissals, (d) shortening the advance notice period from 6 to maximum 3 months, (e) reducing the amount of severance pay from half to one-third of the monthly pay and defining the maximum to 6 pays, and (f) relaxing the definition of mass lay-offs.

16. Strong trade union opposition has delayed agreement within the tripartite working group on the draft Labor Law. While the legislation was originally envisaged for adoption by Parliament in mid-2002, the Government has recently announced that the draft law will not be submitted to Parliament in January 2003. Polls indicate that there has been little public support for the proposed changes and employers have not taken an active role in the tripartite discussions.

• Strengthening market institutions and the competitiveness of the economy

17. Croatia’s performance in terms of enterprise restructuring, privatization, new business environment, attraction of FDI, and overall creation of an enabling environment for development of an internationally competitive private sector do not compare favorably to the CEECs which are EU accession candidates. One important aspect of this lack of progress was reflected in the relative lack of hardening of budget constraints on incumbent enterprises. In the context of reforms supported by the SAL, the Government recognized such actions as vital to help reduce the distortions engendered by nonpayments, barter and subsidies—especially in public enterprises. Hardening budget constraints helps to induce restructuring, free resources bottled up in nonviable firms that can be reallocated to more productive uses, and create economic space for new entry. In this regard, the Croatian authorities acknowledged that there is a critical role to be played by accelerating reform of the key public enterprises in terms of eliminating arrears, making payments and requiring sales in cash and on time, and increasing financial transparency to help lead the way for further enterprise restructuring economy-wide.

18. The elimination of arrears and barter of public enterprises is being monitored by the Bank as part of the SAL. Despite a significant decrease in arrears by the end of 2001, overdue receivables and liabilities have not yet been eliminated. The Government is redoubling its efforts on this front and the Bank will continue to monitor the situation closely.

19. In addition to hardening budget constraints on public enterprises, the government plans to undertake a comprehensive privatization program which includes divesting Government stakes in the banks (Croatian Postal Bank which is envisaged to be merged with Croatia banka), the Croatia insurance company, the telecommunications company, the portfolio held by the Croatian Privatization Fund (tourism, shipyards, agribusiness) and energy companies (INA, HEP, and JANAF).

20. The financial sector is in the final stages of privatization and restructuring. The Bank has provided assistance to the Government through the EFSAL, TAL I, and TAL II in addition to the FSAP. More than 90 percent of the banking sector assets have been privatized. The Government recently divested its remaining minority stake in Privredna banka. Progress in privatizing the two remaining state-owned banks has been slow. Privatization of the Croatia insurance company has fallen off track. The Government will pursue a different method of privatization in 2003. The Bank has also played the lead role in assisting the Government in power sector restructuring, and strengthening the regulatory and legislative framework through the EFSAL and through the TAL II loan. Progress, while slower than originally envisaged, is being made in all of these areas. INA is likely to be privatized in the first quarter of 2003. Delays in the restructuring of HEP have led to delays in privatization.

21. Although a modern bankruptcy law was adopted in 1996 and amendments were passed in 2000, the bankruptcy system in Croatia does not function in a satisfactory manner. The reason for this is largely due to an inadequate institutional capacity of the commercial court system to handle bankruptcies expeditiously and efficiently and the inability to enforce collateral contracts. Reforms are needed to address: outdated court and case management; inexperience of commercial judges, trustees and receivers in the modern bankruptcy regime; inadequate trust by businesses in the bankruptcy process; and lack of confidence by the population in the efficiency of the overall judiciary system.

22. The Bank is now providing technical assistance to the Government (in cooperation with USAID) in this area through the Court and Bankruptcy Administration Project in addition to monitoring reforms in the context of the SAL. The Government has drafted provisions to improve the legal and institutional framework for Croatia’s bankruptcy regime, including a law on certification of receivers (trustees) and amendments to the law on bankruptcy and the law on court registry.

23. An accounting and auditing ROSC report, prepared by the Bank in 2002, is based on an assisted self-assessment of accounting and auditing standards and practices in Croatia conducted under the management of a National Steering Committee consisting of representatives from government and the private sector. The self-assessment exercise specifically focused on the strengths and weaknesses of the institutional arrangements needed for the observance of International Accounting Standards (IAS) and International Standards of Auditing (ISA). The Accounting Act was amended in 1992. These amendments took the important step of requiring all companies to prepare IAS financial statements. The Audit Law requires that audits should be carried out by a certified auditor licensed under authority granted by the Ministry of Finance and in accordance with ISA. Therefore, Croatia does not suffer from a “standards gap”. However, there is significant lack of compliance with IAS and ISA and there is no enforcement or monitoring of compliance.

24. The National Steering Committee has approved a Country Action Plan consistent with the issues raised in the ROSC report. The Plan includes greater conformity between Croatian law and EU Directives, better monitoring of compliance with IAS and ISA, strengthened regulation and supervision of the audit profession, more efficient and effective requirements for the filing, and enhanced public access to corporate financial information.

25. Conditions in Croatia for new business entrants, including a dynamic SME sector, are not hospitable. Like other transition countries, Croatia inherited from the previous system a preponderance of large enterprises and a business culture which emphasized economies of scale, mass production, vertical integration and self-sufficiency (in-house production instead of subcontracting/outsourcing). SMEs offer the promise to generate competition, expand employment, increase exports and introduce new technologies. The emergence and development of SMEs has been stifled by, among other problems: difficulties and complexities in business licensing and registration (identified by the FIAS study on Administrative Barriers to Investments), other barriers for investment (ineffective land register and cadastre, long delays in granting visas and work permits), and the lack of a well-coordinated and articulated pro-SME policy in the country.

26. The Government is implementing an Action Plan that aims to improvee Croatia’s investment policy regime (both FDI and domestic investment) by bringing the fiscal, regulatory and legal policy framework in line with best international practice. The Action Plan is monitored on a quarterly basis by the Government and the Bank as a component of the SAL. Thus far, several components of the Action Plan which require legislative changes have been adopted by Parliament, while several others are pending approval. The pending changes include: ensuring electronic access to every public notary office; shortening the approval period for construction license; abolishing location permits; shortening the visa and work permits process time; reducing administrative fees; streamlining registration procedures; and reducing registration costs.

• Strengthening Social Protection

27. Croatia has a wide-ranging system of social transfers targeted at groups that are needy. However, despite relatively high levels of spending, the system fails to provide adequate protection to the most vulnerable members of society. Substantial resources are allocated to programs which are not explicitly targeted to the poor. The few programs that are well targeted do not receive sufficient funding. Apart from the Poverty Assessment carried out by the Bank in 1999, there is little information on the targeting efficiency of social assistance programs. The system suffers from a multiplicity of benefits, which adds substantially to administrative costs and overall system complexity. As a result, the overall objective of poverty alleviation is inefficiently addressed.

28. The reform program of the SAL contains four key objectives: (i) ensuring a more coordinated approach to benefits, and changes in benefits policy; (ii) re-allocating resources towards programs that are well-targeted; (iii) ensuring more community-based social service delivery on grounds of both cost and quality; and (iv) improving the information base on which to monitor poverty reduction and the impact of policy changes.

29. The Government has prepared a draft national strategy for combating poverty which has been sent to the Parliament for discussion. The document lays out a coordinated strategy across the range of Government agencies to reduce poverty. In October 2001 the Government took steps in rationalizing benefits by harmonizing with the rest of the population the tax allowances of war veterans and invalids as well as privileged pensioners. At the same time the Parliament adopted a new child benefit law which enhanced the targeting effectiveness of child allowances. The Government has already taken steps to improve the availability of reliable and nationally representative household survey data through expanding the household budget survey to cover the entire country. The recently collected national census data (carried out in April 2001) will be used to update sample design and create a reliable basis for policy-relevant data analysis.

World Bank Group Strategy and Lending Operations

30. The Bank’s Board discussed the CAS for Croatia in June 1999 and a CAS progress report in September 2001. The progress report determined that policy reform in Croatia, while slower than anticipated in the CAS, was sufficient to place Croatia in a “base case” lending scenario. The base case triggers included adoption of fiscally sound budgets in 2000 and 2001, full pay-out under the deposit insurance scheme, privatization of three banks, bankruptcy proceedings against six insolvent banks, initiating the privatization of the largest state-owned insurance company, adoption of a telecommunications regulatory framework and invitation to strategic investors in the telecommunications company (HT), initiating restructuring/privatization of oil and gas, and maintaining satisfactory performance of 90 percent of the Bank portfolio.

31. The overall objectives of the CAS are: (i) supporting a sustainable fiscal policy while enhancing effectiveness of public expenditure; (ii) maintaining financial stability and continued financial sector reforms; (iii) reducing the size of the State; and (iv) improving governance.

32. Currently, there are eleven Bank supported projects (10 investment loans and 1 adjustment operation) totaling US$524.1 million under implementation in Croatia: the Farmer Support Services Project (US$17 million) became effective in July 1996, the Coastal Forest Reconstruction and Protection Project (US$42 million) became effective in July 1997, and the Investment Recovery Project (US$30 million) became effective in March 1998. The Reconstruction Project for Eastern Slavonia, Baranja and Western Srijem (US$40.6 million) became effective in January 1999. The Municipal Environmental Infrastructure Project (US$36.3 million) was approved in June 1998, the Railway Modernization and Restructuring Project (US$101 million) in January 1999, Technical Assistance II (US$7.3 million) in April 1999 and the Health System Project (US$29 million) in October 1999. The Trade and Transport Facilitation in Southeast Europe (US$13.9 million) became effective in May 2001. The Court and Bankruptcy Administration Project (US$5 million) became effective in January 2002, and the SAL (US$202 million) became effective in February 2002, with a first-tranche disbursement of US$102 million in the same month. A GEF financed US$5 million grant for the Karst Ecosystem Conservation Project was signed on June 19, 2002.

33. Two investment projects (the Pension System Investment Project [US$27.3 million] and the Registration and Cadastre Project [Euro26 million]) were approved by the Board in August and signed in September 2002. Both are expected to be effective by end-2002.

34. Investment projects currently under preparation include: the Rijeka Gateway Project (approximately US$150 million), the Coastal Cities Pollution Control Project (approximately US$100 million), the District Heating Project (approximately US$30 million), and the Social Protection Project (approximately US$36 million). A Social and Economic Recovery Project is also under consideration.

35. As of May 2002, the IFC had 7 projects in its portfolio for a total of US$114.9 million (US$82.3 million for its own account) and had approved pending commitments for three other projects for a total of US$28.7 million. The projects are: (1) a US$2.5 million equity participation in TS Bank; (2) a US$2.2 million loan to a small regional bank based in Split, for the financing of small and medium-sized enterprises; (3) a US$6.0 million equity investment and a US$15.4 million loan investment in a paper mill plant, aimed at rebuilding and modernizing the facility; (4) a US$5.0 million equity investment in a venture capital fund; (5) a US$12.2 million loan to a regional bank for a credit line for on-lending to small and medium-sized enterprises; (6) a US$15 million loan and US$6.1 million equity investment to modernize a ship repairing facility in Rijeka; (7) a US$37.5 million loan and US$10 million equity investment in the leading pharmaceutical complex in Croatia; (8) a US$3 million equity investment in a pension management company; (9) a US$5 million loan and US$1.2 million equity investment in a Croatian leasing company; and (10) a US$16 million loan and US$3.5 million equity investment in Croatia Banka as a pre-privatization facility. The IFC is seeking to expand its activities in Croatia, focusing on financial market development, manufacturing, agribusiness, tourism, and infrastructure privatization.

Questions may be referred to the following Bank staff: Mr. Broadman (ext. 31312), Mr. Courtney (385 1 235 7215) and Ms. Madzarevic-Sujster (385 1 235 7260), Mr. Funck (ext. 30874).

APPENDIX III Croatia: Statistical Issues

1. The economic database in Croatia is of mixed, though improving, quality. Data on monetary aggregates have the least problems and are close to meeting the recommendations of the IMF Monetary and Financial Statistics Manual. In other areas, major deficiencies impact adversely the reliability and timeliness of macroeconomic analysis. In most cases, remedial action has been taken to improve data coverage and reliability, but in some instances progress has been impeded by insufficient budgetary support and lack of cooperation between government agencies. The recent creation of a joint committee between the Ministry of Finance and the Croatian National Bank should promote collaboration in the statistical area to advance the reconciliation of government finance and monetary data. Croatia has subscribed to the SDDS and its metadata are posted on the DSBB (http://dsbb.imf.org).

A. National Accounts

2. National accounts (NA) data systems have undergone substantial improvement in the last few years, enabling publication of a broader, and more comprehensive, set of NA data. The Central Bureau of Statistics (CBS) compiles and publishes annual constant and current price data according to the production, income, and expenditure approaches. On June 30, 1999, the CBS began publishing quarterly GDP data by expenditure and main industry groupings at current and constant (1997) prices, thus meeting the SDDS target date. Nonetheless, shortcomings remain which limit the coverage and hinder the reliability of the estimates. These include: a lack of quarterly source data for the seasonally volatile agricultural sector; incomplete coverage of the informal sector; inadequate conversion of government finance statistics from a cash to an accrual basis; insufficient access to preliminary or unpublished source data; inadequate source data for measuring changes in inventories; inadequate price deflators; and incomplete coverage of unincorporated businesses and the self employed (farmers, trade and crafts). A particular problem is connected with the late publication of annual data, which generally present large differences with quarterly data. After the abolition of the payments agency (ZAP) in late 2001, enterprise financial statistics are collected by the finance agency (FINA). Further improvements are currently being implemented and a new project for the production of regional GDP statistics has been recently started.

B. Prices

3. The CBS produces monthly indices of retail and producer prices, and a monthly cost of living index based on the consumption basket of a typical low-income, non-farm household. Data are collected around the 20th day of each month, and the indices are released on the last working day of the month. However, price statistics are calculated using outdated weights on the basis of a small sample of observations. No import or export price deflators are produced, thereby hindering analysis of external sector developments. A new consumer price index will be released in April 2003. The main characteristics of the new index will be: a) its weighting structure, based on the household survey (rather than on the retail survey, as in the old retail price index), to be revised every five years; b) the use of the geometric mean (as opposed to the arithmetic mean in the old RPI) to aggregate elementary series; c) the application of “implicit” quality adjustment. At the same time, the harmonized CPI will be calculated in line with Eurostat methodology, but will not be released for the time being to avoid confusion. A core inflation index will also be calculated based on a methodology developed by the CNB.

C. Wages and Employment

4. Croatia produces data on average net and gross earnings per person in paid employment by industrial sector, and employment by industrial sector. Earnings data include bonuses, sick pay, and meal allowances, and are based on monthly surveys covering 70 percent of workers in permanent employment in each industrial category. It does not cover a significant part of the working population, including persons employed in trade and crafts, contract workers, farmers, and military and police workers.

5. The number of registered unemployed overstates the actual level of unemployment. A preliminary Labor Force Survey, which meets ILO standards, was conducted for the first time in 1996 on 7,200 households. The sample has been subsequently expanded and the survey is now being conducted on a regular basis with semi-annual results, released only after a delay of about five months. The difference between the survey-based unemployment rate and that based on registered unemployed is generally of about six percentage points.

D. Fiscal Data

6. A large amount of data on government finance statistics is produced on a monthly basis with lags of between three and twelve weeks, and is available in the Monthly Statistical Review of the Ministry of Finance or provided directly to the Fund. Revenue data on a GFS basis are reliable and available on request on a next-day basis for most major categories for both the central budget and the extrabudgetary funds. Expenditure data on a cash basis are available according to GFS methodology (economic and functional classification) for the central budget and the extrabudgetary funds. A new chart of accounts was used to develop the 2002 budget for part of general government entities. Budget users “own revenues”, excluding universities, have been brought into the 2002 budget. The data on central government financing in the Ministry of Finance reports, the monetary survey and the balance of payments are not reconciled. Substantial discrepancies exist partly due to different definitions of government by the Ministry of Finance and the central bank.

7. Data on the stock of government debt suffer from certain deficiencies although a new CNB database represents a major improvement. The detailed data on domestic public bonds published in the Monthly Statistical Review of the Ministry of Finance are now compounded by a central government debt table in the CNB Monthly Bulletin, which also reports stocks of central government guaranteed debt. However, data on expenditure arrears—formally recorded for the first time at the end of 1999—, promissory notes and receivable issues linked to banks privatization are not included.

8. Data on the operations of local governments and consolidated general government are available only on an annual basis and with a considerable lag.

E. Monetary Data

9. Data on the monetary survey (including separate records for deposit money banks) and the balance sheet of the Croatian National Bank (CNB) are published monthly with four and two week lags, respectively, meeting the SDDS requirement. Key data such as currency in circulation, reserve deposits, and international reserves of the CNB are available on request with a one-day lag. A new statistical reporting system which enables banks to report in a single set of forms their balance sheets, reserve requirements, interest rates, etc., was introduced on July 1, 1999, together with a new chart of accounts. Following the recommendations of the Monetary and Financial Statistics mission that visited Croatia in 2001, attempts have been made by the CNB and the Ministry of Finance to reconcile the monetary statistics and the government finance statistics data. However, data from the CNB on net credit to government continue to be inconsistent with the data on the financing of government from the Ministry of Finance. As a subscriber to the SDDS, Croatia regularly disseminates the information on its international reserves and foreign currency liquidity in a template according to the IMF methodology. The data is disseminated monthly on the IMF and CNB external websites. The CNB is planning to extend its statistical framework to balance sheet information of investment funds and insurance companies.

F. Banking Statistics

10. Banks’ lending and deposit rates are published monthly in the CNB Monthly Bulletin. Banks’ annual financial statements tend to understate the riskiness of their assets by misclassifying loans to certain sectors and by booking “big bonds” (government bonds issued to clear outstanding enterprise debt) and other assets at face value even though some of these assets trade at a large discount. This produces a misleading picture of the quality of bank assets, leading to underprovisioning of bad assets and overstatement of capital adequacy ratios. A change in sampling has introduced a break in the interest rate series since January 2002.

G. Balance of Payments Data

11. Balance of payments data are compiled on a quarterly basis according to the fifth edition of the IMF’s Balance of Payments Manual, and published by the CNB making use of information from commercial banks, the CNB, and the Ministry of Finance, among other entities. The data are generally available with a lag of three months and are subject to substantial revisions in subsequent releases; however, trade data are available with a lag of four to six weeks and data on international reserves are available the next day by request. In January 1998 a major revision of balance of payments statistics took place which led to the evaluation of imports on an f.o.b. basis and the inclusion of goods imported into free trade zones. The new surveys on transportation, travel, government services, and labor income were introduced in 1999. While the survey of transportation delivers very accurate estimates, the other three surveys still need improvements. Also since 1999 valuation changes have been excluded from the asset side of currency and deposits in the banking sector (a major improvement). In mid-2001 new surveys on communication and insurance services were introduced and a survey of construction services is being prepared. During 1999 and 2000, the CNB has increased the coverage of the direct investment survey by identifying additional enterprises. The coverage and quality of portfolio investment data are reasonably complete and accurate.

12. The coverage of external debt data improved in 1999 with the publication of information on external debt by debtor. A large part of Croatia’s external debt was contracted prior to the dissolution of the former SFRY and Croatia’s share was agreed with Paris and London Club creditors in 1995 and 1998, respectively. This information has further improved in 2000 with the introduction of the new CNB database. Foreign debt statistics are available on request on the same day, but certain breakdowns (e.g., external public and publicly guaranteed debt by creditors), loans received by the resident household sector, and credits received with a maturity of less than 90 days are not covered in the standard reports. Also, there is still a problem of identifying payments arrears; however, the authorities are in the process of updating their database for earlier years in order to identify genuine arrears, if any, and record them in the balance of payments.

13. Annual data on the international investment position are disseminated on the CNB website with a six-month delay.

Table 14.

Croatia: Core Statistical Indicators

(As of December 26, 2002)

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APPENDIX IV Croatia: Sustainability Analysis

1. Fiscal and external debt sustainability assessments were conducted over the medium term. To ensure the robustness of the staffs projections, the standardized sensitivity tests were applied to the staffs baseline projections.

A. Fiscal Sustainability

2. The staffs baseline scenario predicts a decline in the public debt to GDP ratio of 6½ percentage points between 2002 and 2007. When the historical average values of real interest rate, real GDP growth, and primary balance are used throughout the projection period, the public debt ratio climbs to 62¼ percent by 2007, about 11 percentage points higher than in the baseline. This is mainly explained by the fact that the baseline assumes a much lower primary deficit with tight fiscal consolidation than its historical average. The isolated shocks to real interest rate, real GDP growth, and primary balance for the first two years were added to the baseline. The public debt ratio increases most seriously with the negative primary balance shock, while the real interest rate shock does not lead to a significant deterioration of the debt dynamics. In all three types of isolated shocks, the debt ratio would resume its decline once the impact of the shocks fades. The same is true for the combination of these shocks. A one-time 30 percent real depreciation in 2003 increases the debt ratio by 17¼ percentage points, due to the high foreign currency denominated share in public debt. Similarly to the cases of negative shocks to various macro variables, the debt stock starts declining once the depreciation shock disappears. The same is true for a one-time 10 percentage point of GDP increase in the public debt ratio. An isolated adverse shock to public revenue does not lead to a sizeable worsening of the debt dynamics.

B. External Sustainability

3. Under the baseline scenario, the external debt to GDP ratio falls by more than 15 percentage points from 61¾ percent in 2002 to 45⅓ percent in 2007. This decline is achieved mainly through a significant reduction of external borrowing by the general government due to a switch to more domestic borrowing and through the decline in the fiscal deficit. Under the stress testing scenario 1 (interest rate, Croatian U.S. dollar GDP deflator growth, non-interest current account, and non-debt creating flows as a percentage of GDP are all at their historical average), the debt to GDP ratio rises to about 86 percent by 2007, mainly due to a lower GDP growth rate and significantly higher levels of external borrowing necessary to finance the larger current account deficit. Croatia appears to withstand relatively well isolated stresses to interest rates and GDP growth rates (scenarios 2 and 3). The isolated shocks to the U.S. dollar GDP deflator and the current account (scenarios 4 and 5) and a combination of shocks to various macroeconomic and external variables (scenario 6) lead to more adverse results. The debt to GDP ratio increases to about 82—87 percent in the case of isolated shocks to the U.S. dollar GDP deflator and the current account, while it surges to more than 100 percent in the case of the combined shock. A one-time 30 percent depreciation leads to a large increase in the debt to GDP ratio in 2003 (to more than 87 percent), but the debt ratio starts declining once the impact of this shock fades away.

Figure 6.
Figure 6.

Croatia: Fiscal Debt Sustainability Analysis - Baseline and Stress Testing Scenarios, 2002-2007

(As percent of GDP) 1/

Citation: IMF Staff Country Reports 2003, 027; 10.5089/9781451817287.002.A001

Sources: Croatian authorities; and Fund staff estimates.1/ For a description of the scenarios, see Appendix V, Table 15.
Table 15.

Croatia: Public Debt Sustainability Framework, 1997-2007

(In percent of GDP, unless otherwise indicated)

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General government’s cross debt, including arrcars and public guarantees extended to entities outside the general government

Derived as [(r-π(l+g)-g+αε(1-r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate, α = share of foreign-currency

The real interest rate contribution is derived from (the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g

The exchange rate contribution is derived from the denominator in footnote 2/ as αε(l +r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP doflator).

Table 16.

Croatia: External Sustainability Framework, 1997-2007

(In percent of GDP, unless otherwise indicated)

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Derived as [r-g-ρ(l+g)+εα(l+r)]/(l+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ - change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, c = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(l+g) + εα(l+r)]/(1+g+ρ-gρ) times previous period debt stock, ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

Defined as non-interest current account deficit, plus interest and amortization on medium- and long-term debt, plus short-term debt at end of previous period.

ATTACHMENT I Memorandum of Economic and Financial Policies

Zagreb, Croatia

December 27, 2002

Mr. Horst Köhler

Managing Director

International Monetary Fund

Washington, D.C. 20431

U.S.A.

Dear Mr. Köhler:

1. The Croatian authorities have prepared an economic and financial program for 2003 that aims at maintaining macroeconomic stability and strengthening the foundations for high economic growth in the runup to parliamentary elections that must be held by March 2004. To achieve these objectives, the program relies on fiscal adjustment and structural reform (including further privatization) in the context of a broadly stable exchange rate. In support of our program, we herewith request a stand-by arrangement in an amount of SDR 105.88 million (29 percent of quota) to be made available over a 14-month period ending in March 2004.

2. The implementation of our program, which is described in the attached Memorandum of Economic and Financial Policies (MEFP), will be monitored through quantitative performance criteria and indicative targets in the fiscal, monetary, and external sectors. In this regard, the MEFP proposes performance criteria for end-March and end-June 2003 and indicative targets for the second half of 2003. Program implementation will also be monitored through one structural performance criterion and five structural benchmarks, all of which are listed in Annex II of the MEFP. The quantitative performance criteria are described in greater detail in Annexes III-VIII.

3. We believe that the policies and measures set forth in the MEFP are sufficient to attain the objectives of our economic program. However, we will take any further measures that may be needed toward this end. We will consult periodically with the Fund, in accordance with the Fund’s policies on such consultations, about the progress being made in implementing the economic program described in the MEFP, and in advance of any revisions to the policies covered by the MEFP. We will provide the Fund with such information as it requests on policy implementation and achievement of program objectives. In any event, there will be two reviews during the period of the requested arrangement, scheduled to take place by May 15, 2003 and November 15, 2003, in order to (i) set the quantitative performance criteria for September 30 and December 31, 2003 (at the time of the first review) and (ii) assess progress in implementing the program and reach understandings on any additional measures that may be needed to achieve its objectives.

4. In view of Croatia’s comfortable international reserves position and easy access to international capital markets, we have recently repurchased the entire amount of Fund credit outstanding and we do not intend to make the purchases under the requested arrangement that will become available upon its approval and after observance of its performance criteria and completion of its reviews.

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Attachment: Memorandum of Economic and Financial Policies

1. The government and the Croatian National Bank (CNB) have cooperated in the design and adoption of a fiscal and monetary program for 2003, with supporting structural measures, to maintain macroeconomic stability and promote higher rates of economic growth. Our program aims at reducing the fiscal deficit and the government expenditure ratio and at stabilizing the public debt ratio after many years of uninterrupted increases. However, we realize that further fiscal consolidation is required beyond the current program period to attain long-term fiscal sustainability. Our program for 2003 is described in Section II below.

I. The Expected Economic Outcome in 2002

2. Despite a weak external environment, economic growth is likely to have accelerated to 4 percent in 2002 (Annex I). Private consumption, a good tourist season, and strongly rising investment, partly as a result of an ambitious highway construction program, have contributed to this favorable outcome. Inflation has abated further, aided by heightened competition in the retail sector, a broadly stable exchange rate, and the absence of wage pressures. We expect retail prices to rise by 2½ percent on average in 2002. Meanwhile, revised import data indicate that the external current account deficit is likely to decline from 3.8 percent of GDP in 2001 to 3.6 percent in 2002. Notwithstanding the higher than previously reported imports, gross official international reserves are likely to have risen to more than 5 months of imports of goods and nonfactor services by end-2002 as the CNB intervened repeatedly to stem currency appreciation pressures. Despite stepped-up public investment, the general government deficit is expected to be reduced from 6.8 percent of GDP in 2001 to 6.2 percent of GDP in 2002. Both the deficit and economic growth could, however, turn out to be somewhat smaller if the fourth-quarter acceleration in the execution of highway construction were to fall short of expectations.

II. The Economic Program for 2003

3. Our program for 2003 consists of the general government budget, which is part of a three-year fiscal framework covering 2003-05, a monetary program, and a number of supporting structural measures that are described in Section II D below.

A. Objectives

4. In line with our overarching objective of increasing employment and raising the standard of living of the population, our program seeks a further acceleration of economic growth. Despite the dim prospects for the world economy and in particular for our principal export markets in Germany and Italy, we are projecting real GDP to grow by 4.2 percent in 2003. With the foreign contribution about neutral, virtually all of this growth is likely to come from domestic demand. Private consumption and investment are expected to contribute almost 4½ percentage points to growth, while the government sector’s contribution to aggregate demand will be negative despite continued growth in public investment, reflecting strict control of public consumption.

5. In the absence of severe external price shocks (oil prices are now fully passed through to consumers) and with a broadly stable exchange rate, we envisage average retail price inflation to remain below 3½ percent in 2003. Keen competition and lower import tariffs should keep goods prices virtually constant, while services prices are likely to continue rising at an annual rate of 5-10 percent due to lower productivity growth and occasional adjustments of administered prices. This rather sanguine view is underpinned by recent core inflation rates of around 1 percent, producer price inflation that is barely positive, and the absence of significant wage pressures.

6. Our external sector objectives are to maintain the external current account deficit at close to 3½ percent of GDP and to keep the gross official international reserve cover of imports of goods and nonfactor services at above 5 months. The improved regional security situation and better access to foreign markets facilitate the pursuit of these objectives. With a broadly stable exchange rate, their achievement relies primarily on fiscal adjustment, wage restraint, and structural reforms. Under our program, inward direct foreign investment is expected to be large enough to ensure the targeted international reserves buildup while lowering the external debt ratio.

B. Fiscal Policy

7. The principal aim of the government’s fiscal program for 2003 is the stabilization of the general government debt ratio after many years of uninterrupted increases. In line with this objective, the recently adopted 2003 budgets of the central and local governments reduce the general government deficit from an expected 6.2 percent of GDP in 2002 to 5 percent of GDP in 2003. Parliamentary approval of a central government budget and provision of consolidated budget data for the 53 largest local governments that are consistent with the 2003 general government deficit target are a prior action. With a modest amount of privatization receipts (see paragraph 10 below) and no net increase in guarantees (see paragraph 12 below), a deficit of this size is expected to be sufficient to stabilize the debt ratio at its estimated end-2002 level of 57.5 percent of GDP. Although the program represents an adjustment effort of 1.4 percent of GDP (including 0.2 percentage points due to the full-year cost of the introduction of the privately administered mandatory second pillar of the pension insurance system in 2002), the government realizes that additional fiscal consolidation is required in the future to compensate for the eventual disappearance of privatization receipts and to reduce the burden of government debt, whose servicing already requires 2.5 percent of GDP in interest payments (almost as much as the budget for primary and secondary education).

8. The 2003 budget’s revenue projection incorporates the following changes to the tax and social contributions system:

  • A combined revenue loss of 0.5 percent of GDP is estimated to result from an increase in the standard monthly personal income tax deduction from HrK 1,250 to HrK 1,500; a reduction of social security contribution rates from 37.67 percent to 37.20 percent; and an exemption from the 5 percent real estate transaction tax for first-time home buyers.

  • A combined revenue gain of 0.6 percent of GDP is estimated to result from the reduction of the personal income tax deduction for residents of special areas (islands, war affected regions) to the level of the increased standard deduction; the extension of the base for social security contributions to labor compensation from other than regular employment of all groups except students or copyright protected income; and an additional car insurance tax.

The legislation for all these changes (and a few additional ones with only minor revenue effects) has been adopted by parliament and will take effect on January 1, 2003 (prior action). Apart from import tariff reductions under international agreements, the government will not introduce any other changes to the tax and social contributions system. Reflecting in part the full-year effect of the cost of introducing the second pension pillar in 2002, the general government's revenue to GDP ratio is projected to decline by 0.4 percent of GDP despite the expected small increase in net revenue collections resulting from the above-specified measures.

9. The small decline in the revenue ratio adds to the need for expenditure restraint to achieve the deficit reduction target. As the table below shows, restraint on expenditure for wages, goods and services, and subsidies and other current transfers more than accounts for the 1.5 percentage point reduction in the expenditure ratio required to reduce the fiscal deficit to 5 percent of GDP in 2003, thus creating room for higher spending of interest, capital investment and net lending. Key to the success of the fiscal program is a firm wage and employment reduction policy that guarantees adherence to the budgeted wage bill. To this effect, the government has decided to keep the basic monthly wage unchanged at HrK 4,232.43 in 2003. Wage coefficients, which are multiplied with the basic wage to determine actual wages paid, will also remain unchanged except that some 0.1 percent of GDP has been allocated to raise the coefficients of primary and secondary schoolteachers. All central government workers will be entitled to a vacation bonus budgeted at 0.1 percent of GDP, but year-end bonuses will be granted only to the extent that sufficient room is created through net employment reduction. While funds have been provided to expand employment in the judicial and education systems and the Ministry of Finance, a substantial net employment reduction is expected to be achieved as a result of the implementation of the defense sector reform. Starting with some 5,000 layoffs in the first quarter of 2003, the government intends to reduce employment in the Ministry of Defense by some 12,000 in 2003. In accordance with this plan, severance payments, the cost of retraining programs, and wage costs for those re-employed as reservists have been included in the budget. The government will monitor closely the quarterly central government wage bills and will consult with the Fund to ensure achievement of its fiscal deficit target should their budgeted amount be exceeded. While direct subsidies to the railways and the shipyards have been increased, the increased share of all subsidies in terms of GDP is more than offset by lower pension and health related transfers, whose growth is slowed by the phased introduction of the 1999 first-pillar reform and various past and new health reform measures. In addition, savings of a little more than 0.1 percent of GDP result from the replacement of special court-mandated payments under the recently expired small pension law by a lower, permanent payment stream. In line with the government’s strong commitment to development, capital expenditure (particularly for highways) continues to expand, raising its ratio to GDP to 6.8 percent. Notwithstanding its overall restraint, the 2003 budget includes 0.4 percent of GDP in expenditure for education and judicial reforms, research and development, and transfers to restructure state agricultural enterprises.

Croatia: Consolidated General Government Expenditure, 2002-03

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10. The financing plan of the 2003 budget relies less on privatization receipts and more on domestic borrowing than in the past. Privatization receipts of the general government are conservatively budgeted at 1.2 percent of GDP (see paragraph 22 below). Any receipts in excess of budgeted amounts will be used to reduce borrowing. However, any shortfalls in receipts will be offset by an equivalent reduction of government expenditure so as to ensure achievement of the debt ratio stabilization objective. To alleviate the appreciation pressure on the exchange rate, help develop the domestic capital market, and provide financial assets to the private pension funds collecting second-pillar contributions, the government intends to rely more than in the past on domestic borrowing. Under the CNB’s monetary program (see paragraph 14 below), there is room for bank credit to the general government of 1.3 percent of GDP. The nonbank sector is expected to be provided with liquidity equivalent to 0.3 percent of GDP from the virtual elimination of remaining central government arrears and it is expected to absorb government paper equivalent to 1.2 percent of GDP, mostly to satisfy the statutory investment needs of the pension funds. Given foreign debt repayment obligations of only 1.6 percent of GDP (due to the absence of bullet bond repayments in 2003), the gross foreign borrowing requirement of the government of 3.1 percent of GDP is less than half of its 2002 level1. Apart from project disbursements and the second tranche of the World Bank’s Structural Adjustment Loan (SAL), this borrowing will be arranged by the Ministry of Finance, starting with a Euro bond issue of €500 million in the first quarter of 2003, to be followed by a Samurai bond in mid–2003.

11. Observance of the government’s fiscal program will be monitored by performance criteria on the central and general government deficits and the change of the stock of central government arrears (Annex III) as well as on net changes in the stock of short-term external debt and on the contracting or guaranteeing of new nonconcessional external debt with a maturity of more than one year of the general government, CNB, and HBOR (including a subceiling on such debt in the 1-5 maturity range; Annex IV). To ensure adequate room for credit to the nongovernment sector, the general government’s net borrowing from domestic banks will be monitored on the basis of indicative targets (Annex V). Finally, local government arrears, which amounted to 0.2 percent of GDP at end-September 2002, will be monitored quarterly by the Ministry of Finance. As a result of a larger share in personal income tax collections, the local governments are expected to achieve a small surplus in 2003, and their own privatization receipts would be sufficient to reduce or even eliminate existing arrears.

12. As agreed under the World Bank’s SAL, the government is developing criteria for issuing government guarantees. To prevent the growth of indirect government debt, which is estimated to rise to 14.7 percent of GDP by end-2002, and achieve the programmed stabilization of the government debt ratio, the Ministry of Finance will issue new loan guarantees only to the extent that room is created by the amortization or expiration of existing ones. No other government body is authorized to enter into financial commitments on behalf of the Republic of Croatia. A government decree to this effect will be issued soon (prior action).

C. Monetary and Exchange Rate Policy

13. The programmed fiscal adjustment and reduced government reliance on external borrowing will greatly facilitate the conduct of monetary policy. As conditions are not yet appropriate for inflation targeting, the CNB intends to pursue its price stability mandate under the new central bank law by continuing to maintain the exchange rate of the kuna broadly stable against the euro. This said, the CNB is prepared to allow sufficient exchange rate variability from time to time to discourage one-way currency bets and it advises economic agents not to incur unhedged foreign exchange positions.

14 The CNB’s monetary program for 2003 aims at maintaining inflation at below 3½ percent, an objective that is considered compatible with both its mandate and broad exchange rate stability. Economic growth and the preservation of confidence in the pre-electoral period are expected to attract sufficient resources to the banking system to allow the unsterilized purchase of USS350 million in international reserves and credit to the government of 1.3 percent of GDP, leaving 6.7 percent of GDP of credit for the nongovernment sector. The implied slowdown of credit expansion from an estimated 29.8 percent in 2002 to a programmed 13.7 percent in 2003 should be facilitated by increased margins for self-financing out of rising profits, the payment of almost all remaining central government arrears, and easy access to foreign borrowing by export-oriented enterprises. Should, however, credit growth fail to slow down soon, the CNB will undertake adequate measures, including the introduction of higher provisioning requirements on banks with excessive credit growth. There are no indications yet of deteriorating loan portfolios, and the CNB has made banks aware of its concerns and is using its supervision to examine the quality of loan portfolios and enforce existing provisioning standards. In terms of monetary policy, the CNB does not see room for reducing reserve requirements, and it stands ready to resist any further reduction in market interest rates during the program period. The pending adoption of a new foreign exchange law (see paragraph 19 below) is expected to provide it greater latitude to make monetary policy more effective.

15. The implementation of the CNB’s monetary program will be monitored through performance criteria on the net usable international reserves and net domestic assets of the CNB (Annexes VI and VII). Should base money demand be weaker than assumed in the CNB’s program, the CNB will tighten credit sufficiently to ensure that its international reserves targets are observed. If, however, base money growth turns out to be stronger than assumed, the CNB will consult with the Fund to determine if the inflation outlook justifies easing the limits on net domestic assets. To ensure that the envisaged room for credit expansion to the nongovernmental sector is not pre-empted by public enterprise borrowing, we have established indicative limits on net domestic bank borrowing by nine large state enterprises (Annex VIII).

D. Structural Reforms
Fiscal sector reforms

16. The new budget law, which will be submitted to parliament in early January 2003 (prior action), requires the submission of an updated three-year budgetary framework with each annual budget, the presentation of all budget data on a consolidated general government basis, and the regular publication of these data. It also strengthens the enforcement of penalties for overspending budget units. This law is expected to be approved by end-March 2003 (structural benchmark). The government is now preparing criteria for issuing guarantees, to be completed by end-March 2003 (structural performance criterion). These are likely to set a minimum social rate of return, to be assessed by the Ministry of Finance, for activities to be covered by the guarantee; restrict the extension of guarantees to private sector companies without government participation; and subject guarantees to the 60 percent of GDP ceiling for the general government debt ratio proposed in the new budget law.

17. Four new funds and agencies have been created under the 2003 budget (the environmental protection fund, the agency for small and medium-sized enterprises, the agency for investment and export promotion, and the state aid agency). Like the fund for regional development and the fund for employment and growth, they have been included transparently in the state budget. The government does not intend to create any new funds or agencies during 2003.

18. The Ministry of Finance needs to strengthen its debt management, macroeconomic analysis, and treasury departments and improve cooperation with the CNB in the areas of policy coordination and data reconciliation. To this effect, the ministry intends to hire suitably qualified staff and reorganize its operations as appropriate during 2003. Technical assistance will be received shortly through the EU CARDS program and, perhaps, from the Fund to enhance debt management capacity, including the monitoring of arrears. Debt management will avail itself of the capabilities of the existing SAP treasury system. Better use of that system will also be made by the treasury for budget preparation and execution and the monitoring of arrears. Technical assistance has already been received, and may be required again, from the Fund to produce high-quality, timely general government data at an appropriate frequency under both the GFS 1986 and GFS 2001 methodologies. In line with the technical assistance recommendations, quarterly and annual general government (with local governments limited to the 53 largest units) data will be compiled from accounting data collected directly from general government units. Finally, a task force comprising staff from the Ministry of Finance, the Croatian Bureau of Statistics (CBS), and the CNB will be formed to reconcile fiscal statistics of the general government. The government will request that the Fund place a resident fiscal advisor in the Ministry of Finance to assist in these reforms. To assess its practices and procedures, the government has decided to request a fiscal ROSC to be prepared by the Fund.

Financial sector reforms

19. A new foreign exchange law is expected to be approved by parliament in late January 2003. It will be consistent with EU standards and with Article VIII of the Fund’s articles of agreement and empower the CNB to introduce temporary restrictions on short-term capital inflows. It will also require that foreign securities eligible for outward portfolio investment by residents must satisfy minimum ratings from international rating agencies.

20. Seven bylaws (on classification of claims, calculation of capital-asset ratios, supervision methodology, auditing decision, consolidated supervision, management of liquidity risk, and operation of subsidiaries) to implement the new banking law have been prepared by the CNB and will be issued by end-2002 for application from January 1, 2004 at the latest. Options will be included in the calculation of net open foreign exchange positions for regulatory purposes; the pertinent CNB regulation will be issued by end-June 2003 (structural benchmark) and implemented by end-September 2003 (structural benchmark).

Public enterprise reform and privatization

21. The government remains committed to divesting virtually all public enterprises and to keep a minority share in only some of them. The privatization fund (HFP) expects to reduce its pooled portfolio of some 1,100 companies to about one half by end-2003. Sales of minority shares are being conducted against privatization vouchers at the Varaždin exchange and by auction at the Zagreb exchange, while majority shares are sold by public tender. Apart from retiring privatization vouchers, these sales are not expected to result in significant cash revenues for their owners (HFP, the deposit insurance agency—DAB, and the pension fund).

22. Outside HFP’s portfolio, the government continues to pursue the restructuring and privatization of most large state enterprises. Binding offers for 25 percent plus one share of the oil and gas company (INA) are expected to be received by January 22, 2003, a deadline that will not be further extended (prior action). The government will decide on the bids received by end-March 2003 (structural benchmark), and the resulting privatization proceeds are expected in the second quarter of 2003. The electricity company (HEP) will complete its unbundling into separate power generation, transmission, and distribution companies during 2003, for possible privatization of power plants in 2004. Like other distribution infrastructure, the JANAF pipeline will not be privatized. After two failed attempts, the government has given up on selling a majority share in the insurance company (CO) by public tender. Instead, it plans to sell 30 percent of the company in 2003 on the Zagreb stock exchange. Finally, 7 percent of shares in the telecommunications company (HT) will be sold to its employees in the second quarter of 2003.

23. The government has decided to make the postal bank (HPB) acquire Croatia Banka, for which no buyer has been found. The financial performance of HPB has improved considerably after a capital increase, the sale of its nonperforming portfolio to HFP, and restructuring and cost cutting measures. The bank is now well capitalized and profitable. Nonetheless, the government does not believe that it should own a commercial bank and has therefore decided to privatize it in stages, first by selling 25 percent to the IFC in 2003 and then by selling at least another 26 percent to a strategic investor in 2004. The preparation of a privatization plan satisfying these requirements by end-March 2003 is a structural benchmark under the program, which will be monitored in consultation with the IFC.

Product and labor market reforms

24. To enhance the functioning of markets and encourage the growth of employment, the government is preparing new company, competition, and labor laws. The company law is expected to be submitted to parliament by end-2002 for approval by end-March 2003. The competition and labor laws are expected to receive parliamentary approval by end-February 2003. Government approval of a draft labor law that:

  • reduces severance pay to no more than one third of a month’s salary per year of service with a ceiling of six monthly salaries;

  • shortens the advance period for dismissals to a maximum of three months for workers with at least 20 years of service;

  • relaxes the definition of mass layoffs to the dismissal of no less than 20 workers within 90 days; and

  • eases the preconditions for valid dismissals, especially in small firms; is a prior action under our program. Finally, a new bankruptcy law aimed at accelerating bankruptcy procedures and allowing payouts to creditors before the completion of all procedures is expected to be approved by end-March 2003.

25. Aided by additional funding under the 2003 budget, judicial reform will proceed, e.g., by encouraging out-of-court procedures and using single judges instead of panels of judges to settle and adjudicate commercial disputes.

26. Our CEFTA membership takes effect on March 1, 2003. A free trade agreement with the Federal Republic of Yugoslavia was initialed in November 2002 and is expected to come into effect soon. Other free trade agreements are being negotiated with Estonia, Latvia, and Moldova. While CEFTA has agreed to apply the Pan European Rules of Cumulation of Origin immediately, the government is still negotiating with the EU on the application of this agreement to Croatia’s exports. Under our program, we will not impose or intensify restrictions on the making of payments and transfers for current international transactions, introduce or modify multiple currency practices, conclude bilateral payments agreements that are inconsistent with Article VIII of the Fund’s articles of agreement, or impose or intensify import restrictions for balance of payments purposes, nor will we accumulate external payments arrears (to be monitored on a continuous basis).

ANNEX I Croatia: Key Macroeconomic Indicators

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Sources: Croatian National Bank, World Economic Outlook, and Fund staff estimates.

In 2000, includes 0.5 percent of GDP in back taxes.

Gross reserves adjusted downward by foreign currency redeposit requirements held at the CNB, and by the amount of outstanding foreign currency CNB bills.

On a remaining maturity basis. Coverage is limited to short-term debt contracts registered with the CNB.

ANNEX II Croatia: Monitoring the Implementation of the Program

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To be monitored on a continuous basis.

ANNEX III: I. Limits on the Cumulative Deficits of the Consolidated central and General Governments

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Indicative limits (not a performance criterion).

Provisional (performance criteria and privatization targets to be specified at the time of the first review).

The above listed ceilings on the cumulative deficit of the consolidated central government cover: (i) central government operations, that is, the central government budget (the Office of the President, the parliament, the government, the constitutional court, all ministries, other independent state administration and judicial bodies); (ii) existing central budgetary funds (health, pension, employment, water management, employment and growth, regional development, and environmental protection funds) and agencies (the agencies for state aid, for investment and export promotion, and for small and medium-sized enterprises); and (iii) the highway (HAC) and road (HC) construction and maintenance agencies, the privatization fund (HFP), and the bank rehabilitation and deposit insurance agency (DAB). In addition to (i) - (iii), the consolidated general government comprises (iv) the 53 largest local governments (20 counties, Zagreb, and 32 other cities). The government will not establish new budgetary or extrabudgetary funds or agencies during the program period, but any such funds or agencies would be covered by the ceilings. The ceilings do not include the operations of the Croatian Bank for Reconstruction and Development (HBOR). HBOR’s deficit in 2003 is projected to be HRK 1,803 million and will be monitored separately under the program.

The above listed ceilings will be reduced by the amount by which the cumulative quarterly privatization receipts of the consolidated central and general governments (as defined above) fall short of the amounts indicated.

The limits on the deficits of the consolidated central and general governments will be adjusted downward to offset the net effect of any reduction in interest payments attributable to rescheduling of existing government debt.

For purposes of the program, the deficits of the consolidated central and general governments will be defined on a modified accrual basis, i.e., all expenditure should be on a “payment due” basis. The cost for recapitalizing banks and public enterprises, and payouts of insured deposits will be considered as “above the line.” The following will be considered as “below the line”: privatization receipts, net change of arrears, inssuance and payment of promissory notes issued by the Ministry of Finance and the Health Fund, the collection of tax arrears, bonds issued for financing the recapitalization of banks and public enterprises or payouts of insured deposits, redemption of government bonds tendered by the CNB in connection with bank resolution, and any release of foreign-held blocked foreign assets of the former SFRY to the government. Purchases and sales of general government securities in the secondary market do not finance the general government deficit and must therefore be excluded from the data reported to the Fund. For bank financing, this includes secondary market transactions with domestic nonbanks and nonresidents. For domestic nonbanks, this includes such transactions with domestic banks and nonresidents.

For purposes of program monitoring, all financing flows in foreign currency will be converted at the following average exchange rates (in HrK per unit of foreign currency):

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Fiscal performance will be monitored monthly at the consolidated central government level and tested quarterly at the consolidated central or general government level. As local governments still need to adjust to more frequent than semi-annual reporting, performance will be tested at the central government level at end-March and end-September 2003 and at the general government level at end-June and end-December 2003. The pertinent data will be provided in all cases in GFS 1986 classification within 30 days from the end of the month. The monthly monitoring will be based on the narrow consolidation of the central government (i.e., excluding HAC, HC, DAB, HFP, and HBOR) and separate monthly reports from HAC, HC, DAB, and HFP. Unlike the monthly monitoring, which relies on a variety of sources, the quarterly testing is based on accounting data (classified on the basis of the new chart of accounts) with direct links to GFS 2001, except for HAC, HC, DAB, and HFP, which must be converted to GFS 1986 separately.

Cumulative quarterly performance will be assessed from above the line and below the line, whichever is larger.

II. Limits on the Cumulative Changes of the Stock of Central Government Arrears

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Provisional (performance criteria to be specified at the time of the first review).

Arrears include (i) all payments overdue according to their original or modified terms; and (ii) any promissory notes issued by the Ministry of Finance and the central budgetary funds. Arrears comprise both domestic and external payments arrears. The stock of arrears will be provided monthly to the Fund by the Ministry of Finance within 30 days.

III. Indicative Limits on the Consolidated Central Government Wage Bill

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Provisional (indicative limits to be specified at the time of the first review).

The cumulative wage bills exclude employers’ contributions to social security. These limits do not constitute performance criteria. If wage payments exceed these limits the government will consult with the Fund on the timely adoption of measures to ensure observance of the cumulative deficit limits specified in Section I above.

ANNEX IV Ceilings on the Net Changes of the Stock of Short-Term External Public and Publicly Guaranteed Debt and on New Contracting or Guaranteeing of Nonconcessional External Debt by the Public Sector

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Provisional (performance criteria to be specified at the time of the first review).

For program purposes, the term “debt” has the meaning set forth in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85), adopted August 24, 2000), which reads as follows: “(a) For the purposes of this guideline, the term “debt” will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future points in time; these payments will discharge the principal and/or interest liabilities under the contract. Debts can take a number of forms, the primary ones being as follows: (i) loans, i.e., advances of money to obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans, and buyers’ credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements); (ii) suppliers’ credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and (iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property. (b) Under the definition of debt set out in point 9(a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt.” However, for the time being lease contracts will not be covered by the ceilings- A reporting system for lease contracts is currently being set up by the Ministry of Finance. Once completed, leases will be included in the debt contracting ceilings.

The short-term debt limits refer to the cumulative net changes in public sector debt disbursed and outstanding with an original maturity of up to and including one year. These limits do not apply to normal import-related credits and nonresident deposits in state-owned banks (HPB, HBOR).

For medium- and long-term external debt, the performance criterion applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt, but also to commitments contracted or guaranteed for which value has not been received.

The ceilings on medium- and long-term external debt apply to the contracting or guaranteeing of new noncessional external debt with an original maturity of more than one year, and, within this limit, with an original maturity of more than one year and less than 5 years. Concessional loans are defined as those with a grant element of at least 35 percent, using currency-specific discount rates based on the six-month average commercial interest rates reported by the OECD (CIRRs) for loans with maturities of less than 15 years, and on the 10-year average CIRRs for loans with maturities of 15 years and more.

The ceilings on medium- and long-term public debt (but not the subceilings) will be raised by the amount by which the government retires existing debt before its scheduled maturity.

The public sector comprises the consolidated general government as defined in Annex III Section I, the CNB, and HBOR. Excluded from the limits are HPB, the public enterprises, performance guarantees on the construction of ships (for no more than the value of advance payments), and changes in indebtedness resulting from refinancing and rescheduling, including the capitalization of interest in arrears.

The above limits also do not apply to guarantees by the general government for suppliers’ credits related to imports for constructing ships during the period until delivery of the ships takes place. In case of orders for multiple ships, the import related credits could take the form of revolving external credit lines. To monitor such guarantees, data on the guarantees extended for ship building, including performance guarantees or bonds, and the payments and deliveries for ships built with these guarantees will be supplied on a quarterly basis.

Debt falling within the limits shall be valued in U.S. dollars at the average exchange rates indicated in Annex III.

Information on the contracting and guaranteeing of new debt falling both inside and outside the the limits will be reported monthly to the Fund within 30 days by the CNB.

ANNEX V Indicative Limits on the Cumulative Changes in the Net Credit of the Banking System to the Consolidated General Government

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This stock of claims consists mainly of the counterpart to frozen foreign exchange deposits and “big bonds,” which are restructuring bonds issued in 1991 and 1992, and held by banks in lieu of claims on enterprises; the total stock of claims as of December 31, 2002 also includes the bonds issued to finance the payout of insured deposits in failed banks.

Provisional (indicative limits to be specified at the time of the first review).

The quarterly limits are cumulative. The consolidated general government is as defined in Annex III, Section I.

For program purposes, net credit of the banking system to the consolidated general government is defined as all claims of the banking system on the consolidated general government (excluding HBOR) less all deposits of the consolidated general government (excluding HBOR) with the banking system.

Data on banking system claims on and liabilities to the consolidated general government are taken from the balance sheets of the banks and the CNB, and will be provided monthly to the Fund by the CNB within 30 days.

Foreign currency flows derived from stocks at December 31, 2002 and the most recent quarter tested shall be valued at the average exchange rates of the quarter in question, indicated in Annex III.

ANNEX VI Floors under the Cumulative Changes in the Net Usable International Reserves of the Croatian National Bank

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Provisional (performance criteria to be specified at the time of the first review).

For purposes of the program, net usable international reserves of the Croatian National Bank (CNB) are defined as the U.S. dollar value of gross foreign assets minus reserve assets held against foreign currency deposits by domestic banks and against CNB foreign exchange bills minus gross foreign liabilities minus off-balance sheet foreign currency obligations.

For purposes of the program, gross foreign assets shall be defined as monetary gold, holdings of SDRs, any reserve position in the IMF, and holdings of foreign exchange in convertible currencies by the CNB. Any return to the CNB of blocked foreign assets that are not part of CNB foreign assets as of December 31, 2002 will be added to the reserve floor. Reserves that are pledged, frozen or used as collateral shall be excluded from the gross foreign assets. In particular, any reserve assets pledged to secure government debt will be excluded from the reserves definition.

For purposes of the program, reserve liabilities shall be defined as all liabilities of the CNB to non-residents—excluding deposits into the special accounts for external debt servicing—with an original maturity of up to and including one year, as well as liabilities arising from IMF purchases and bridge loans from the BIS, irrespective of their maturity. For purposes of the program, reserve liabilities shall also include guarantees provided by the CNB backed by reserves as collateral.

The net forward position of the CNB is defined as the difference between the face value of foreign currency-denominated CNB off-balance sheet claims on nonresidents (forwards, swaps, options, and futures market contracts) and foreign currency obligations to both residents and nonresidents. This position amounted to US$0 million on December 31, 2002. For program purposes, only the off-balance sheet obligations will be deducted from the CNB’s net international reserves position. These liabilities amounted to US$0 million on December 31, 2002.

Cumulative flows in U.S. dollars will be measured by applying the average exchange rates of the most recent quarter, as indicated in Annex III, to the stock of reserves of December 31, 2002 and the end of the quarter in question.

For purposes of the program, the end-of-quarter net usable international reserves of the CNB (including their end-2002 stock) are calculated as the arithmetic average of 21 observations centered on the last business day of each quarter.

The limits will be monitored from data on the accounts of the CNB supplied monthly to the Fund by the CNB within 15 days of the last business day included in the observations.

ANNEX VII Limits on the Cumulative Changes in the Net Domestic Assets of the Croatian National Bank

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Provisional (performance to be specified at the time of the first review).

The net domestic assets of the Croatian National Bank (CNB) are defined as the difference between the base money and the net usable international reserves of the CNB (as defined for program purposes in Annex VI), both expressed in local currency at program exchange rates (see Annex III). Base money is defined as currency outside banks, vault cash of banks, giro and required reserve deposit of banks in domestic currency, and deposit money held at the CNB.

The above listed ceilings shall be adjusted for changes in the required reserves in domestic currency, as follows:

Δ N D A = Δ r ( B 0 D + θ 0 B 0 F ) + r 1 ( Δ B D + θ 1 Δ B F + Δ θ B 0 F )
A01app08lev1sec5
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The adjuster applies only to the changes on account of administrative decisions that were not foreseen in the monetary program.

If base money demand exceeds its projections, the CNB will consult with the Fund to determine whether these limits can be exceeded without jeopardizing the authorities’ inflation target. The projected stocks of base money are as follows:

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Provisional (projections to be specified at the time of the first review).

For purposes of the program, the net domestic assets of the CNB and the monetary base at the end of each quarter (including their end-2002 stock) will be calculated as the arithmetic average of 21 observations centered on the last business day of the quarter.

The limits will be monitored from data on the accounts of the CNB supplied monthly to the Fund by the CNB within 15 days of the last business day included in the observations.

ANNEX VIII Indicative Limits on the Cumulative Increases in the Net Credit of the Banking System to Selected Public Enterprises

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Provisional (indicative limits to be specified at the time of the first review).

The above listed indicative aggregate limits cover the 9 enterprises listed below. Net credit is defined as the sum of all short-term and long-term bank claims in local and foreign currency on these enterprises by banks resident in Croatia plus the amount of credit guaranteed by Croatian banks from domestic nonbank and foreign sources, less the sum of these enterprises’ total deposits in local and foreign currency with such banks. Credit guaranteed by the government or resulting from the calling of performance guarantees will be excluded from the ceilings to the extent that it is not already reflected in the balance sheets of the banks.

The 9 enterprises are as follows:

Enterprises on the above list that are privatized with more than 50 percent in the course of the arrangement will be removed from the limits and the limits will be adjusted downward by the amount of the net credit outstanding to those enterprises at the end of the month preceding privatization. Whenever changes in accounting practices or the set of enterprises reporting to the CNB result in changes in the data series, the Fund will be notified and provided one quarter of data calculated with both the old and new definitions and an offsetting adjustment will be made to the limits. The limits will be adjusted by the amount of any bank or enterprise rehabilitation that writes off or removes these assets and liabilities from the banking system or any debt-equity swaps that convert bank debt into equity in the enterprises. Information regarding such debt-equity swaps will be provided by the Ministry of Economy if and when they occur.

The above indicative limits will be cumulative and will be monitored on the basis of the average quarterly exchange rates (as listed in Annex III) from data collected monthly by the Ministry of Finance (ORESE) and supplied to the Fund within 30 days.
1

See also Republic of Croatia—Staff Report for the 2002 Article IV Consultation, IMF Country Report No. 02/178, July 17, 2002.

2

The statistical institute has recently revised downward GDP data for the last three years. The revision reduces average annual real GDP growth in the period 1999-2001 from 2.5 percent to 1.9 percent.

3

For a discussion of the problems affecting Croatian exports, see S. Dodzin, “Selected Aspects of Export Performance, Competitiveness, and Trade Policy” in IMF Country Report No. 02/179, p.34.

4

See IMF Country Report No. 02/178, p.17, fn. 8.

5

These effects are due to the large inflow of foreign currency deposits associated with euro conversion in late 2001-early 2002. While most deposits have remained in the banking system, banks have substantially increased private sector credit by drawing down their deposits with foreign banks that had been accumulated during euro conversion.

6

Not too much should be made of these trends, however, as nonperforming loans are generally a lagging indicator of credit problems. A risk remains due to lending in, or indexed to, foreign exchange to unhedged borrowers.

7

For a discussion of a more ambitious adjustment scenario, see IMF Country Report No. 02/178, pp. 13-14.

8

The CNB is reluctant to accept exchange rate appreciation to achieve still lower inflation rates as this would likely be perceived as posing risks to competitiveness and might trigger political pressure on its monetary policy.

9

The debt stock monitored under the program includes arrears and guarantees extended to entities outside the general government. In contrast to the previous stand-by arrangement, the proposed one would monitor performance under a broader general government consolidation, including additionally the highway (HAC) and road (HC) construction and maintenance agencies, the privatization fund (HFP), the bank rehabilitation and deposit insurance agency (DAB), and the 53 largest local governments. At the central government level, only the development bank (HBOR) will remain outside the consolidation, but its financial operations will be monitored separately (MEFP, Annex III). Although there are 566 local governments in Croatia, the 53 largest ones account for about 80 percent of local government expenditure.

10

Severance payments, the cost of retraining programs, and wage costs for those reemployed as reservists have been incorporated in the 2003 budget.

11

In addition, net wages of all government workers are estimated to increase by 2-3 percent as a result of the higher standard income tax deduction and lower employee contributions for social security.

12

The authorities’ position is based on the following arguments: the retail price index is still fraught with methodological problems; there is a dearth of leading high-frequency economic indicators; the exchange rate is easier to monitor; broad exchange rate stability is important in the highly euroized and foreign exchange indexed small open economy; continuing financial sector reform makes the transmission process particularly uncertain; and the fiscal imbalances are still large. The staff broadly concurs with this position (see L. Bonato, “Practical Issues in Adopting Inflation Targeting in Croatia” in IMF Country Report No. 02/179, p.23).

13

Again, the staff is in broad concurrence with this view. See S. Dodzin, op. cit.

14

The environmental protection fund, the agency for small and medium-sized enterprises, the agency for investment and export promotion, and the state aid agency.

15

The central government deficit will be the performance criterion for the first and third quarters and the general government deficit in the second and fourth quarters. An asymmetric adjustor regarding privatization receipts will be used to prevent an increase in the public debt ratio (MEFP, Annex III).

16

Local government arrears will be monitored quarterly by the Ministry of Finance (MEFP, paragraph 11).

17

To give the CNB some flexibility in meeting the targets in (v) and (vi), these limits are defined as averages of a period starting 10 business days before, and ending 10 business days after, the quarterly test dates.

18

Following disclosure of foreign exchange trading losses by Rijecka Banka in March 2002, the bank suffered large deposit withdrawals. Thanks to the skillful handling of the episode (prompt liquidity support and immediate reprivatization of the bank), the deposit outflow, which had spread to two other banks, stopped and began to reverse itself in May 2002. For details, see SM/02/230.

1

In addition, a short-term loan to bridge a brief delay in privatization receipts will add 0.5 percent of GDP to both disbursements and amortization.

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Cover IMF Staff Country Reports
Republic of Croatia: Request for Stand-By Arrangement
Author:
International Monetary Fund
Volume/Issue:
Volume 2003: Issue 027
Publisher:
International Monetary Fund
ISBN:
9781451817287
ISSN:
1934-7685
Pages:
95
DOI:
https://doi.org/10.5089/9781451817287.002
  • Figure 1.
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    Figure 1.

    Croatia: Real Sector Developments, 1996-2002

  • Figure 2.
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    Figure 2.

    Croatia: Retail Price inflation, 1996-2002

    (Annual percent change)

  • Figure 3.
    View in gallery
    Figure 3.

    Croatia: Exchange Rates Development, 1994-2002

  • Figure 4.
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    Figure 4.

    Croatia: Money and Bank Credit, 2000-2002

    (Annual percentage changes)

  • Figure 5.
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    Figure 5.

    Croatia: Public Debt Stock, 1997-2002

  • Figure 6.
    View in gallery
    Figure 6.

    Croatia: Fiscal Debt Sustainability Analysis - Baseline and Stress Testing Scenarios, 2002-2007

    (As percent of GDP) 1/

Figure 1.

Croatia: Real Sector Developments, 1996-2002
Figure 2.

Croatia: Retail Price inflation, 1996-2002

(Annual percent change)
Figure 3.

Croatia: Exchange Rates Development, 1994-2002
Figure 4.

Croatia: Money and Bank Credit, 2000-2002

(Annual percentage changes)
Figure 5.

Croatia: Public Debt Stock, 1997-2002
Figure 6.

Croatia: Fiscal Debt Sustainability Analysis - Baseline and Stress Testing Scenarios, 2002-2007

(As percent of GDP) 1/