Statement by Jeroen Kremers, Executive Director for the Republic of Croatia

Croatia has made important strides in restoring robust economic growth and achieving price stability while continuing to strengthen its net international reserves position under the Stand-By Arrangement. Executive Directors welcomed this development, and stressed the need to improve fiscal consolidation, accelerate structural reforms, tighten monetary stance, and maintain the soundness of the banking system. They appreciated the budget, foreign exchange, labor laws, and emphasized the need to focus on public enterprise restructuring and privatization, and promote Croatia's European Union membership bid.

Abstract

Croatia has made important strides in restoring robust economic growth and achieving price stability while continuing to strengthen its net international reserves position under the Stand-By Arrangement. Executive Directors welcomed this development, and stressed the need to improve fiscal consolidation, accelerate structural reforms, tighten monetary stance, and maintain the soundness of the banking system. They appreciated the budget, foreign exchange, labor laws, and emphasized the need to focus on public enterprise restructuring and privatization, and promote Croatia's European Union membership bid.

Overview

1. This year, an election year, the Croatian authorities commenced with the second precautionary SBA. This arrangement helps them in signaling their determination to continue with the reforms embarked on since 2000. The EU accession efforts further bolster these fiscal, structural and political reforms. The authorities are on track with the program; the economy is growing at a strong pace, resilient to unfavorable external conditions; and the financial markets have rewarded this performance by decreasing the country’s risk premium. The Croatian authorities thank staff for the support and policy advice during the last years, helping the country to manage transitional maladies.

2. The authorities - aided by advice from the staff - have managed to change the economy for the better. The public administration has been reformed, improving efficiency and reducing the wage bill; a pension reform has been carried out (introducing a second and third pillar) as well as a health reform; labor market flexibility has been increased by modifying the labor law; and market functioning has been improved by adopting new bankruptcy, company and competition laws. Also, the banking system has been restructured; it is now 90 percent foreign owned. At the same time, the central bank’s degree of independence has been augmented, in line with EU legislation. Although the economy has been transformed significantly in the last years, many difficult tasks and challenges lie ahead.

3. The future tasks and challenges are foremost embodied in achieving sustainable nominal and real convergence in accordance with the Maastricht framework as well as concluding the process of harmonizing domestic with EU laws. Also, a further reduction in the budget deficit is targeted while aiming for a lower tax burden. Furthermore, the authorities will strengthen the capacity of public administration as a necessary step towards EU accession. Beside the advances in the fiscal area, additional strengthening of the overall institutional framework is foreseen as well as reforming the judiciary system. Finally, the authorities are committed to maintaining the momentum of structural reforms by privatizing the remaining two state-owned banks, the hotel industry, agricultural conglomerates and the energy utility.

4. A current challenge the authorities are facing is the deterioration of the balance of payments. The widening external current account deficit and increasing external debt, owing to steady robust domestic credit growth, led to a tightening of monetary policy. A “corset” on bank lending and banks’ foreign borrowing brought about this tightening. These measures are seen as short-term, precautionary as well as prudent to take off some “heat” from the economy. The rise in the external deficit and external debt has not concerned the financial markets. In fact, in July 2003, Fitch revised Croatia’s sovereign credit rating outlook to positive from stable.

5. The SBA quantitative criteria for the first quarter have been broadly met. The authorities regret missing the performance criterion target regarding the development of criteria for the issuance of government guarantees and therefore request a waiver. This condition has been executed by now. In the interim, some data have become available, indicating that the fiscal and monetary program is on track. For the remaining performance criteria for the second quarter, the authorities request a waiver of applicability.

6. The prospects for keeping the public debt ratio stable have brightened further. In 2002, the general government debt has stabilized at a level of just over 40 percent, and total debt (including guarantees) at about 51 percent of GDP. In addition, Croatia has recently privatized 25 percent of INA, the state-owned oil company, receiving US$ 143 million more than projected. In accordance with the SBA, the authorities will use this amount for debt repayment.

Monetary policy

7. Inflation remains low. In June, the annual inflation rate was 1.1 percent. The exchange rate remains stable and the already high foreign reserves increased further, above 5.5 months of goods and services imports.

8. A recent challenge for monetary policy has been to slow down expanding domestic bank lending financed through foreign debt rather than domestic deposits. The monetary authorities used two measures. The first measure constrains bank lending to the private sector to 16 percent annually. Growth rates above 4 percent quarterly are penalized by an obligatory purchase of CNB bills at a penalty interest rate. The second measure discourages excessive foreign borrowing by stipulating that liquid foreign assets must be held for not less than 35 percent of foreign liabilities. Both measures attempt to decelerate bank lending to the private sector.

9. These measures are set for a limited time and correspond to the particular characteristics of the domestic money market, one of which is a weak interest rate transmission mechanism. Therefore, a more orthodox measure was not deemed a viable option for the authorities at this stage.

10. The measures taken by the monetary authorities had an effect. During the first half of 2003, lending growth was down to about 8 percent from 15 percent during the same period in 2002. In the first quarter, further signs of the economy’s cooling off are reflected in retail sales’ growing by only 7.3 percent compared to 12.0 percent in 2002.

11. The effects of the monetary measures taken will continue to be closely monitored. If these measures prove not to be sufficiently effective, the authorities stand ready to introduce further measures. In his recent speech to the parliament, the Governor announced that monetary policy could entail an increase in the minimum reserve requirement and capital restrictions in accordance with the new foreign exchange law. Any such measures will be in accordance with the IMF Article VIII.

External sector

12. The external current account deficit widened by 3.4 percentage points to 7.1 percent in 2002. Although it could be considered as substantial, this deficit is not different from many EU accession countries. High economic activity boosted imports and external debt. However, in the first quarter of this year, because of monetary measures the external deficit shrank (in domestic currency terms). In addition, the structure of imports shifted toward capital goods, which should drive faster growth in 2004.

13. The increase in external debt has not shaken the markets’ confidence in the economy’s health. The debt stems largely from the banking system borrowing from banks’ parent companies abroad. Moreover, direct borrowing is well structured, at medium and long maturities. Thus, as staff correctly points out, the country’s EMBI-stripped spread has been decreasing in the last three years to around 100 basis points. And, as already mentioned, the financial markets are viewing Croatia more positively.

Fiscal policy

14. Since 2000, the general government deficit (on accrual basis) declined by 3.7 percentage points of GDP, to a targeted 4.6 percent in 2003. This was achieved despite supply side policies embodied in motorway construction and maintenance worth 1.6 percent of GDP in 2002. The motorways are important for tourism growth and for leveling out imbalances in regional development. At the same time, government expenditure arrears have been almost fully repaid.

15. In 2002, public debt stood at 40.1 percent of GDP. Together with the total stock of guarantees, general government debt amounted to 50.8 percent of GDP. This places Croatia amid the average EU accession performers. The data has been revised in close cooperation with Fund staff to account for some double counting in issued guarantees. The authorities realized the deficiencies in this area. A fiscal advisor, as part of a technical assistance project carried out by the Fund, and fiscal ROSC will serve to improve debt management and data quality further.

16. Debt management further supports monetary tightening. More precisely, the government increased the share of domestic borrowing. Apart from issuing domestic non-indexed bonds (0.5 percent of GDP), the authorities deposited receipts from the recent samurai bond issuance abroad for future debt repayment.

Structural reforms

17. The authorities have undertaken several difficult reforms. Recently, the parliament has passed new laws - the company, the competition, the bankruptcy and the labor laws. The laws have been drafted in cooperation with the World Bank. Implementing these laws will improve market functioning. In addition, the labor law should enhance labor market flexibility and further boost the continuous trend in declining unemployment.

18. In addition to implementing new laws, the authorities have made further progress in privatizing state-owned companies. Despite a strong public debate, the authorities privatized 25 percent of the state oil company INA. The privatization receipts exceeded the anticipated amount by approximately 0.5 percent of GDP and will be used for reducing public debt. Furthermore, negotiations are under way between the authorities and IFC to privatize HPB (the postal bank). By end-2003 privatization plans regarding Croatia Banka, another small state-owned bank, are to be submitted. In addition, some companies in the tourism and agricultural industry have been privatized.

Conclusion

My authorities look forward to continued fruitful cooperation with the Fund. In this respect, the Executive Board’s support for the conclusion of the first review under the precautionary SBA will be welcome. It constitutes a further step in supporting Croatia’s determination to carry on with reforms and to improve further its market position.