Republic of Croatia: Request for Stand-By Arrangement

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 12).

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)

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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 56). 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).