I. Introduction and Overview

1. This collection of papers provides background analyses on the key policy challenges facing Croatia that were the focus of the Article IV consultation—namely, accelerating growth on a sustainable basis and reducing external and financial vulnerabilities. Success on these fronts is critical for achieving the authorities’ ambitious medium-term macroeconomic objectives specified in their Strategic Development Framework for 2006–2013.¹

2. Raising the economy’s actual and potential growth rate will require significant productivity-enhancing reforms. Chapter II examines the factors and constraints that affect recent and potential growth, as well as policies that can influence it. On current policies, it estimates Croatia’s potential growth rate at 4–4½ percent, a result reasonably robust to different methodologies. To increase growth to a higher rate in line with the authorities’ aspirations, the analysis highlights the critical need to improve the business environment through further measures to reduce the administrative burden, legal uncertainties, and corruption. It also emphasizes the importance of attracting more greenfield foreign direct investment, and reforms to reduce the role of the state in the economy through fiscal consolidation and faster privatization.

3. A significant reduction in public expenditure would be needed to simultaneously provide room for cutting taxes, also with a view to boosting growth, and lowering the budget deficit to help narrow the current account deficit. Using the IMF’s Global Fiscal Model, the analysis in Chapter III suggests that a strategy of cutting expenditure and taxes while also reducing the deficit would stimulate investment and labor supply, leading to higher output and consumption, and a lower current account deficit. Moreover, the benefits of such a strategy would increase at least proportionately to the degree of ambition in reducing public expenditure. The simulations suggest that a corporate income tax cut could produce strong benefits. The simulations also suggest that cuts in social security contribution rates, by raising employment and improving competitiveness, have clear merits, which are likely to be even higher than in the model simulations. In any event, with Croatia’s expenditure-to-GDP ratio well above regional peers, there is surely scope for significant expenditure savings.

4. Balance-sheet analysis indicates that vulnerabilities have increased, in particular in the private non-financial sector. As indicated in Chapter IV, this reflects a rapid build-up of external debt and deepening financial euroization in Croatia. Expressed as a percentage of GDP, gross, net, and short-term external debt rose sharply between 2000 and 2005, while the debt service burden has remained broadly stable, helped by low international interest rates in that period. This debt build-up has been fueled mostly by private demand for credit, as the public sector net financial position has not significantly deteriorated. However, firms and households have accumulated large net liabilities that are sensitive to changes in exchange and interest rates. These increased vulnerabilities place a premium on avoiding sharp exchange rate and interest rate movements. They also imply an important role for prudential supervision, including gathering accurate information on the financial positions of firms and households, and preventing an excessive build-up of banks’ foreign currency exposures to unhedged clients.

5. Rapid credit growth raises banks’ susceptibility to an economic downturn. Chapter V finds that a growth slowdown could have a large negative effect on bank capitalization, by affecting borrowers’ ability to service their loans. Banks should therefore build buffers during good times either by raising capital or provisions on unidentified losses, rather than relying on collateral as much as they do now. The analysis also finds that Croatian banks are not necessarily passing on the higher risk of foreign exchange-linked loans to unhedged clients by charging higher interest rates, possibly due to the strong competition among the top banks. Thus, the possibility that the risk premium embedded in loan interest rates is too low makes building up provisions or raising capital even more important. These conclusions are consistent with analyses undertaken at the Croatian National Bank.