Introduction

Mid-2004, Croatia obtained candidacy status for EU membership, and accession negotiations will commence early 2005. Market analysts have already acknowledged this political and economic accomplishment; in July, S&P improved Croatia’s outlook to positive from stable. The accession process will anchor future reforms and economic policies. These will be undertaken according to defined government plans, and it is foreseen that these plans are tackled within the framework of the requested precautionary Fund program and the World Bank Country Assistance Strategy to benefit from their effect in catalyzing good policies domestically, as well as to enhance external credibility and knowledge transfer. The authorities are aware of the remaining structural and economic weaknesses that need to be addressed fully. In particular, the fiscal slippages toward end-2003, when lack of monitoring and some excessive spending ended up in a higher-than-envisaged fiscal deficit. This has led partly to the increase in external debt and is addressed under the requested Fund program. Hence, enhancing fiscal consolidation and transparency is at the core of the authorities’ economic program to stabilize and subsequently reduce external debt, as demonstrated by the supplementary budget and the three-year rolling general government budget passed recently in parliament.

EU accession

The country enjoys EU ‘market economy status’ and numerous issues related to the aquis communitaire have been resolved under the Stability and Association Agreement. Therefore, entering the EU in 2007 appears feasible, albeit challenging. Overall, the accession process will be conducive to advances in structural reforms in the legal, regulatory and judicial areas, to achieve harmonization with the EU and remove administrative obstacles. In the fiscal area, pre-accession funds are treated with caution. It is well understood that, while available pre-accession grants will ease the financing of expenditures, matching these funds is likely to lead to increased spending pressures to be compensated elsewhere.

Fiscal stance

The Fund program target is to stabilize and subsequently reduce overall external debt driven by the fiscal sector and private foreign-owned banks. Therefore, the primary goal is fiscal consolidation and public sector restructuring. In 2004, according to the supplementary budget, the fiscal adjustment will amount to 1.8 percentage points of GDP, with a deficit of 4.5 percent of GDP. By 2007, the deficit is to be reduced to 2.9 percent of GDP, notwithstanding the expenditure pressures related to EU accession.

Staff notices correctly that in the first year some short- and long-term revenue measures aid the fiscal adjustment, instead of additional restraint in current expenditures. There are several external aspects affecting adversely current expenditures, therefore rendering a different expenditure composition in 2004 difficult. First, to increase fiscal transparency, the Railway Company (HŽ) has been integrated into the budget, terminating the previous practice of financing parts of its current operations off-budget. Second, the authorities will need to provide the appropriate environment for the return of refugees, as agreed with the EU. Third, in the last quarter of 2003, the previous government raised the wage bill by 8 percent starting in 2004 without completing the downsizing of the administration. Fourth, hospital arrears accruing to previous years have had a significant impact on current expenditures. Finally, current spending is not as high as it may appear from the staff paper. The overall impression from the peer comparison in Table 8 (p. 35) is somewhat biased in that it incorporates countries which include the informal economy in their GDP. This is not the case for Croatia.

The authorities desire a Fund program with high ownership and high credibility, reflecting their own policies in Fund program conditionality. Hence, the 2004 budget is needed to stabilizing the fiscal stance, increasing transparency, and refocusing on domestic financing. In the next two years, this will be followed by deeper changes in the expenditures composition. In this regard, during the first six months of being in power, the government has undertaken several concrete measures. In the health sector, 30 new long-term savings measures have been introduced mid-2004. The decision has been taken to moderate capital spending. More precisely, the new four-year motorway investment plan is set to be published end-2004 slowing down capital spending in the following years. Finally, improvements in monetary and fiscal policy coordination have taken root; the government has changed plans to issue samurai bonds, and instead issued bonds on the domestic market, albeit at higher interest costs. Institutional investors hold substantial amounts of the issued domestic debt, therefore having an impact on foreign indebtedness.

Structural measures

To gather public support for reforms, the government has adopted and is in the process of publishing plans for the period 2004 – 2007. These have four main pillars. The first pillar refers to the aforementioned fiscal consolidation and enhanced transparency including the Railway Company and other extra-budgetary institutions, most notably the Motorway Company and the Road Company, into the automated single treasury account by 2005. This will improve budget execution monitoring. The second pillar refers to subsidy reductions and increased efficiency of the administration. The authorities intend to decrease subsidies by 1.2 and the wage bill by 1.5 percentage points of GDP by 2007. The third pillar defines the reallocation of budgetary means to growth-enhancing sectors. This implies reallocating spending from the defense sector and capital expenditures for infrastructure to education and science. Furthermore, social and health spending will need to be significantly reduced and targeted more efficiently. Here, the second round of pension reforms and the health care reform will play a crucial role. Finally, the fourth pillar reflects privatization and tax reform plans. The plan is to restructure the public sector and reduce the overall tax burden, which is recognized as one of the elements impeding stronger greenfield investments.

Monetary policy

Financial intermediation has grown strongly in Croatia, and as a result, foreign-owned-banks have a lion’s share in mounting external debt. More precisely, US$ 720 million or 38 percent of the gross external debt increase in 2004 is associated with banks and their leasing companies. Despite this, credit growth in 2004 abated compared to 2003, portfolio quality has not deteriorated, and profitability remains high. In addition, since around 90 percent of the banking sector is foreign owned, it is widely accepted that risk management is advanced. In terms of banks’ external indebtedness, loans from parent companies have long maturities. At the same time, non-resident deposits are unlikely to be prone to reversals, since parent banks are major regional players and, hence, walking away could involve exposure to reputational risk.

Nevertheless, the authorities are not proponents of the Lawson doctrine¹ - in July, the CNB introduced a 24 percent unremunerated reserve requirement for new foreign borrowing. Hence, from August onward, banks will have to deposit as reserves 24 percent of borrowing from abroad. This should assist the efforts of fiscal policy to stabilize overall external debt. The CNB has refrained more from intervening in the foreign exchange market compared to previous years, mostly to moderate appreciation pressures. Foreign exchange reserves are at comfortable levels of over 5 months of goods and services imports. Besides, in conducting monetary policy, the CNB continues to be geared toward building on an already strong track record of low and stable inflation. Finally, by end-2004, circumstances permitting, the CNB will introduce open market operations.

In sum, the authorities’ intention is to lock in EU-membership expectations, reforms, and economic policies with Fund and World Bank program conditionality to pave the way to EU accession. Croatia has benefited in many respects from the close cooperation with the Fund over the years. Without this intense cooperation, obtaining the EU candidacy status would have been more difficult. In this regard, the authorities would like to thank management and staff for the ongoing open and fruitful discussions.