Republic of Croatia: Selected Issues

International Monetary Fund. European Dept.

doi:10.5089/9781475564488.002.A001

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Republic of Croatia

Selected Issues

Author: International Monetary Fund. European Dept.

Publication Date:: 13 Nov 2012

eISBN:: 9781475564488

Language:: English

Keywords:: ISCR; CR; export; productivity; product; ULC; enterprise restructuring; binding constraint; Croatia's labor market; growth in Croatia; Croatia's competitiveness; Total factor productivity; Labor force participation; Labor taxes; Eastern Europe

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This paper on Selected Issues was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on October 23, 2012. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of the Republic of Croatia or the Executive Board of the IMF.

Abstract

I. What Has Kept Croatia’s Growth Low and How to Boost it?¹

In the past decade, Croatia’s GDP growth has lagged behind growth in most emerging markets including its European peers. Croatia’s sub-performance is most notable since the crisis from which it has not yet recovered. The paper investigates the main reasons behind this weak performance and proposes specific policy recommendations to boost growth potential, drawing on three strands of economic thought: (i) the Spence Commission’s Growth Report; (ii) the “Growth Diagnostics” approach of Haussmann–Rodrik–Velasco; and (iii) the Washington Consensus. The policy prescriptions coming from these three approaches are very similar: (i) increase work incentives to boost labor force participation and improve labor market flexibility, which will help regain competitiveness; (ii) improve business environment and foster competition to help attract capital, particularly FDI, into the tradable sectors; and (iii) continue the fiscal consolidation efforts to reduce macroeconomic risks and thus improve the cost and availability of capital. Estimates suggest that the impact of these reforms on growth could be quite substantial, potentially raising growth by about 2 percent in the medium to long term.

A. Croatia’s Growth Performance

1. Croatia’s GDP growth per capita in 2000–2011 averaged 2½ percent. This is below the growth performance in most middle-income countries and in most of Croatia’s Eastern European peers.² Countries such as Argentina, Peru, Thailand, Slovak Republic, Bulgaria, or the Baltics have achieved substantially higher rate of growth over this period.

2. Even accounting for convergence, Croatia’s growth performance remains modest. Its GDP growth rate in the past decade has been lower than what could be expected, even taking into account its relatively high GDP per capita, while others have done much better by the same metric (text chart).

3. Croatia’s sub-performance is particularly notable for the last three years. Real GDP growth per capita averaged 4.1 percent over 2000–2008. While this looks relatively sound, this performance is significantly weaker than some of its emerging Europe peers with similar (Estonia, Slovak Republic) and even higher (Czech Republic or Slovenia) initial GDP per capita (Appendix Figure 1). The growth differential is even larger in the crisis and post-crisis period where Croatia underperformed most of its middle-income and CEEC peers.³ Not only was Croatia hit strongly by the global crisis in 2009 (registering an annual real GDP growth rate of -6.9 percent), but it has not yet recovered from it (with an average annual growth rate of -0.7 percent in the last two years).

4. Estimates suggest that Croatia’s GDP growth has been primarily driven by capital accumulation. The contribution from total factor productivity was more limited while labor contribution was low. Estimates using a Croatia specific production function⁴ (text table) or based on a cross-countries growth accounting exercise⁵ (Appendix Figure 2a and 2b) show the same results. As expected during the crisis years, the contribution from capital was reduced due to lower investment while labor and TFP contribution fell strongly and more than in most peers. The relatively low TFP growth in Croatia is puzzling given the high capital accumulation, which is usually conducive to high TFP growth.

GDP growth and contributions

5. Unfavorable demographics and low activity rate explain the low contribution of labor to growth before the crisis. Employment growth in Croatia has been lower than in most middle-income and emerging Europe countries (Appendix Figure 3). This is partly due to a very low growth of working-age population as the economy is ageing.⁶ In addition, starting from a relatively low level, the participation rate has further declined over time, while it has increased in other peers such as Estonia or Bulgaria. On the other hand, employment rate has been increasing more in line with peers, although some countries (such as Slovakia, Lithuania, or Bulgaria) have done better. This suggests that the problem in the pre-crisis period may have been predominantly connected with labor supply issues. During the crisis, the fall in employment (about -2.5 percent per year) was one of the most dramatic registered in middle-income countries. This was largely the result of the sharp fall in demand for labor, although falling population and participation rate further worsened the picture.⁷

6. The growth accounting exercise suggests that Croatia’s far-from-perfect pre-crisis growth model has run its course. The capital accumulation driven pre-crisis growth model did not generate significant productivity gains and its record of employment creation was limited due to labor supply constraints, questioning its sustainability given the growing external debt. Growth significantly fell in 2009 and has not yet turned positive since then. As capital risks being less forthcoming and more expensive in the future than in the pre-crisis period, a fundamental change in Croatia’s growth model is needed to return to a reasonable medium-term GDP growth and reverse the sharp increase in unemployment.

7. In order to gain more insight into the reasons behind Croatia’s moderate growth performance and provide policy recommendations to boost medium-term growth, the rest of the paper will look into three strands of economic thought: (i) the Spence Commission’s Growth Report; (ii) the “Growth Diagnostics” approach of Haussmann-Rodrik-Velasco; and (iii) the Washington Consensus. Growth Report; (ii) the “Growth Diagnostics” approach of Haussmann–Rodrik–Velasco; and (iii) the Washington Consensus.

B. The Spence Commission Growth Report ⁸

Content

8. The report brought together the views of a Commission of 19 leaders, mostly from emerging markets and developing countries, and two academics (Robert Solow and Michael Spence). Their aim was to identify the characteristics of successful growth stories, using 13 high-growth economies (which have grown at an average rate of at least 7 percent a year for at least 25 years) as examples, and explore how other countries could emulate them. The report identified several policy ingredients for growth that could be regrouped into five different categories.

Full exploitation of the global economy

9. High-growth countries fully exploited the opportunities provided by the global economy and were notably characterized by:

Strong reliance on exports to increase economies of scale and specialization;
High level of FDI and imported technology, using measures to attract FDI (such as promotion campaigns) and measures to extract more knowledge from foreign investment (via joint venture for instance).

High rate of investment

10. If the high-growth cases are any guide, investment rates above 25 percent (counting both public and private investment) seem needed to grow fast. Strong investment in infrastructure (5–7 percent of GDP), notably in ports, roads, airports, telecommunications and power as well as high investment in human capital (with the combined public and private investment in education, health and training amounting to about 7–8 percent of GDP) appear particularly important.

Macroeconomic stability

11. During their most successful growth periods, the 13 high-growth cases avoided large macroeconomic volatility. Factors that seem particularly crucial are:

Stable and single digit (but higher than 2 percent) inflation;
Light exchange rate management, which should at best serve two purposes: (i) slightly favor exports in the early stages of development; (ii) prevent a surge of capital inflows;
High domestic savings to finance investment;
Removal of capital controls only when the structural transformation of the economy is well advanced and the financial sector is matured enough.

Market allocation of resources and strong resource mobility

12. Governments in high-growth economies did not resist to the process of structural change and “creative destruction” in their economies. High growth economies were characterized by strong competition and notably easy entry and exit of firms on the market. High mobility of resources (notably of labor) was also a feature of all 13 high-growth cases.

Quality governance

13. High-growth economies were leaded by committed, effective, and capable governments, which: (i) understood that successful development entails a decades-long commitment; (ii) recruited the right persons and gave them the right incentives (salary linked to performance); (iii) were pragmatic in their approach, tried, failed and learned from their mistakes and were ready to change policies when the situation evolved; (iv) exposed their ideas to quality debates (for instance, reform teams composed of a small number of highly qualified and dedicated technocrats were created in Korea, Japan, Malaysia, and Taiwan).

Application to Croatia and policy lessons

14. With respect to these key growth ingredients, Croatia performed relatively well regarding the investment rate and macroeconomic stability. Investment rates in Croatia averaged 24 percent of GDP in 2000–08, only slightly below the 25 percent minimum level advocated in the Spence Report and comparing favorably with the country’s middle-income or emerging Europe peers, even those with high GDP growth rate (text chart). The investment ratio however declined post-crisis, from 28 percent in 2008 to 22 percent in 2011. Investment in infrastructure was also elevated in Croatia (Appendix Figure 10), while the education level of the labor force appears broadly adequate (at least at the secondary education level, while the share of labor force with tertiary education is lower, Appendix Figure 4). Macroeconomic stability has also been largely ensured with an average inflation rate of 2.9 percent in 2000–11, a broadly stable nominal exchange rate providing an anchor for inflation expectations and financial stability, and high level of domestic savings.

15. However, with respect to the other key growth-generating factors, Croatia’s performance has been much less outstanding. While FDI inflows to Croatia (averaging about 5 percent of GDP over 2000–11) have been in line with other middle-income countries, they have been lower than in many other European partners (Appendix Figure 5). In addition, they have largely been directed to non-tradable sectors rather than to manufacturing, limiting their contribution to improving productivity and competitiveness. FDI inflows however sharply fell in 2010–11, notably in non-tradables, reflecting the crisis in the financial sector and the construction bust.

16. Croatia is also a relatively closed economy, with its share of export of goods and services amounting to about 40 percent of GDP, well below the 50–55 percent reached on average in other CEECs or the fast growing middle-income countries (above 70 percent). Croatia’s trade openness has also remained strikingly constant over time while its rapidly growing peers enjoyed increasing trade integration which helped them support their GDP growth (Appendix Figure 5).

17. Labor market flexibility is limited due to strong employment protection and strict regulations, particularly in the public sector. Hiring and firing costs are high, notably due to high tax wedge on labor, relatively high severance payments, numerous administrative loops for collective dismissals and pro-labor bias of courts, all of which considerably raise dismissal costs. There is also little flexibility to adjust working hours. Collective agreements (with a coverage of 50–60 percent), especially in the public sector, contribute to wage rigidities as, until recently, they could not be changed without explicit trade union agreement and all provisions of a collective agreement of definite duration continued to be valid after it expires until a new agreement has been signed (the so-called “after-effect”). Indicators of structural competitiveness (such as the global competitiveness index or economic freedom index) also point to the lack of flexibility of the labor market as a key obstacle to investment in Croatia. Rigid labor market regulations as well as generous social benefits (notably the low penalty for early retirement, low statutory age of retirement, generous sick leave benefits) have led to a very low labor force participation, among the lowest in middle-income countries, as well as very high unemployment (13 percent in 2011).

18. Croatia also ranks poorly in terms of competition and product market efficiency, as reflected in the indicators of business environment (Appendix Figures 6a and 6b). These indicators all points to the same deficiencies, namely the high taxation, the high regulatory obstacles for starting or conducting a business (and particularly the slow procedures for obtaining a construction permit and registering a property and barriers to investment at the local government level), the inefficient legal framework (poor competition policy, low investor protection, slow resolution of insolvency), the inefficient and wasteful government spending and the slow process of privatization and enterprise restructuring. On the positive side, Croatia ranks well on infrastructure and education, and moderately well on macroeconomic environment (except on budget balance).

19. Finally, several governments have been slow in addressing the long-standing competitiveness problems. The government launched a comprehensive and well-targeted reform package called the Economic Recovery Program (ERP) in April 2010. However, implementation has been slow and patchy due to strong resistance from vested interests. Progress has been made in some areas (notably reduction in health expenditures and unemployment benefits, pension reform), but very limited reforms have been launched to foster labor market flexibility, improve business climate, and reduce the size of the public sector. The general government wage bill is higher than in most new EU member states, mainly as a result of high public sector employment. In addition, a highly compressed pay structure and poor link between salary and performance work as a disincentive to attract and retain quality workers in the public sector.

20. If these 13 high-growth cases are any guide, the key policy recommendations for Croatia would be:

increase labor market flexibility;
improve business environment;
improve government efficiency, through administration rationalization and reform of the pay structure.

These reforms are likely to facilitate economic restructuring, foster competition, and help attract more capital in the tradable sector, thereby increasing Croatia’s competitiveness and openness.

C. The “Growth Diagnostics” Approach

The methodology

21. Haussmann, Rodrik, and Velasco (2005) develop a framework for growth diagnostics that identifies the binding constraints on growth in a country. The goal is to help set up the policy priorities which will provide the biggest bang for the reform buck and hence use the scarce political capital of reformers most efficiently. The framework is based on two equations:

One for capital accumulation per capita, which is a function of the difference between the rate of return on capital net of tax and the world interest rate;
Another one expresses the rate of return on capital as a function of total factor productivity (TFP), complementary factors of production, and externalities.

22. The exercise of growth diagnostics simply consists of reviewing and analyzing these factors to ascertain by a process of elimination which are the most binding constraints on growth. The main idea of the analysis is that if one factor is scarce and a binding constraint for growth, its price should be elevated and economic growth higher when the constraint is relaxed. The decision tree below helps to identify the most binding constraint on growth. The starting point is to determine whether the problem of low investment is due to too high cost of financing or low private return on domestic investment. Depending on the answer to this question, the analysis moves along the decision tree to identify where the most problematic issue is.

Application to Croatia

The pre-crisis period

23. Applying the growth diagnostic to Croatia suggests that during the pre-crisis period (2000–08), capital accumulation does not seem to have been the binding constraint to growth. Several elements support this conclusion:

Low rate of investment? As seen in the previous section, Croatia’s investment to GDP ratio at 24 percent in 2000–2008 does not seem low compared to its peers (Appendix Figure 7).
Bad international finance? The large capital inflows to Croatia in the last decade suggest that Croatia was able to attract foreign savings. Also interest on bonds as shown by the CDS spreads were relatively moderate compared to Croatia’s peers and declining during the period (Appendix Figure 7).
Bad local finance? Domestic savings were ample, while relatively low and decreasing interest rates on loans and deposits do not suggest scarce capital. Real lending rates for corporates were relatively close to real GDP growth in 2000–2008, also not indicating any major issues with the cost of capital (Appendix Figure 8).

24. This exercise seems therefore to suggest that prior to the crisis the major constraint on Croatia’s growth has not been the low level of investment but the poor allocation of this investment. This is probably due to an inefficient allocation of capital into low valued-added sectors and overall low production efficiency:

As shown above, Croatia’s total factor productivity improvement over 2000–2008 has indeed been lower than in most of its Eastern European partners.
The structure of production was also largely titled towards non-tradable sectors, with a particularly low share of industry (Appendix Figure 9).
Also, capital flows, including FDI, were mostly directed towards consumption-related and inward-oriented sectors rather than towards productivity enhancing investment. Investment in industry averaged only 20 percent, significantly less than in other CEECs. On the other hand, Croatia invested significantly more than its peers in financial, construction and tourism sectors (Appendix Figure 10).
Evidence for the EU and the US shows that these non-tradable sectors were in general a weaker source of productivity growth (Appendix Figure 11). The inefficient allocation of capital in Croatia could hence explain the low TFP and GDP growth in the pre-crisis period despite the relatively strong investment ratio.

Crisis years (2009–2011) and future growth

25. While the level of investment does not seem to have been a constraint in the pre-crisis period, it could have become one since the crisis. As noted above, investment has fallen sharply since 2009 with total and private gross fixed capital formation decreasing by more than 10 percent annually over the last three years, leading to a much lower contribution of capital accumulation to growth. FDI inflows have more than halved since 2009. As above, a process of elimination based on the decision tree could help identify the key constraint for growth.

High cost of finance? International finance has become scarcer since 2009 with lower capital inflows, higher global risk aversion and higher CDS spreads for Croatia (text chart and Appendix Figure 12). There is a risk that capital flows may be less forthcoming in the future given Croatia’s elevated external debt to GDP ratio and low growth prospects, possible further deleveraging by euro area banks, and better country differentiation by markets, although EU accession could help boost capital inflows in the medium-term. In addition, while domestic savings has remained relatively high and deposit rates moderate, credit growth has fallen significantly since early 2009. Real lending rates are also above their pre-crisis level, reflecting higher banks’ funding costs and the need for banks to keep lending-deposit spreads elevated to compensate for growing provisions for NPLs.
Low social returns? Social returns remain high with Croatia’s central location in Europe, ready access to the sea and long coastline underpinning its tourism industry. As said above, public expenditure on infrastructure and education has been high and does not seem to be a major constraint for growth.
Low appropriability owing to elevated risks? Market failures do not appear to have been a major issue in Croatia given reasonable levels of innovation (with R&D expenditure and patents granted broadly in line with its peers, Appendix Figure 13). However, large fiscal deficits have significantly increased public debt level, with debt dynamics being now unsustainable in the absence of strong fiscal consolidation. External vulnerabilities have also increased over last years with external debt reaching 100 percent of GDP, external financing requirement of about a third of GDP, and a high degree of euroization. In addition, the poor business environment (as detailed above) and well as the high wage and taxation level have likely impeded growth. Using Haussmann, Rodrik and Velasco’s terminology, higher macro and micro risks have reduced the return of investing in Croatia, thereby contributing to the decline in capital inflows and investment.

Policy recommendations for Croatia based on the growth diagnostic

26. The analysis shows that Croatia’s binding constraints for growth have evolved over time. Before the crisis the level of investment was not a constraint for Croatia’s growth, as it was able to attract high foreign capital flows. Rather, the poor allocation of capital towards non-tradable and low productivity sectors is likely to have been a drag on growth performance. Since the crisis, the deficiencies of Croatia’s economic model and policies, combined with limited and more costly financing have given rise to elevated risks that lower perceived returns on investment in Croatia and have thus emerged as key constraints for growth.

27. While there is not much to be done to influence global risk aversion, a credible and sustainable fiscal consolidation would help. It would reduce Croatia’s vulnerabilities and therefore lower the cost and improve availability of financing. Also, lower public deficit would reduce the risk of crowding out private investment and allow a reduction of the tax burden on labor, thereby improving Croatia’s attractiveness to foreign investors.

28. In addition, several other policies could be implemented to raise the returns on investing in Croatia’s tradable sector and help rebalance the economy. These include measures to:

Improve business environment and Croatia’s attractiveness by easing regulatory obstacles to business, improving the judicial system, and increasing the efficiency of the public administration.
Improve competition and productivity via faster restructuring and privatization of loss-making state-owned enterprises and reduction of subsidies to agriculture and other loss-making sectors.
Increase labor market flexibility by easing labor markets regulations and reducing insider protection. More flexibility in setting wage contracts and lower hiring and firing costs will induce more competitive wage setting and raise the profitability of investment in tradable sectors.

D. The Standard Reform Package or “Washington Consensus”

29. The policy recommendations outlined above could be compared with the set of policy prescriptions aimed at promoting growth that form the core of IMF’s and World Bank’s usual policy advice. This reform package is often referred to as the “Washington Consensus”, as termed by the economist John Williamson in 1989. While the “Washington Consensus” has evolved over time, in a learning-by-doing mode, it essentially relies on three main ideas: liberalization, privatization, and deregulation.

30. Croatia performs well on liberalization. Croatia is already a market economy, open to trade and therefore ranks high in the EBRD transition indicator for price, trade, foreign exchange, bank and interest rate liberalization.

31. Croatia is however lagging in terms of large-scale privatization, enterprise restructuring, infrastructure reforms and competition policy (text chart). While some progress has been recorded on competition policy (due to improvement in law enforcement and further strengthening of the competition law), no progress was made since 2008 in the other three items, highlighting the stalling of the structural reform momentum. Privatization has only seen very slow progress in recent years with the portfolio of state-owned companies still comprising about 645 companies, most of them highly indebted and loss-making, and no clear strategy to deal with them. The lack of progress is also particularly notable for the railway sector, which cannot survive without substantial state subsidies and is uncompetitive compared to other European companies owing to low traffic intensity, low staff productivity, high operating costs, and outdated infrastructure. Despite liberalization since 2008, Croatia’s electricity and gas markets are still dominated by monopolistic suppliers.

32. As a result, the standard policy recommendations for Croatia would focus on policies aimed at:

Accelerating privatization and restructuring of state-owned companies;
Increasing labor market flexibility and easing labor tax burden;
Easing regulatory obstacles to business and strengthening competition.

E. Reform Priorities in Croatia

33. Interestingly, the policy prescriptions from the three approaches reviewed are very similar. They evolve around three themes: (i) increase work incentives to boost labor force participation and improve labor market flexibility; (ii) improve business environment and foster competition; and (iii) consolidate government finances to reduce macroeconomic risks that deter investment. These reform priorities are in line with the structural indicators of competitiveness, which point to these issues as the most problematic obstacles for doing business and investing in Croatia.

34. Reforming Croatia’s labor market should aim at increasing both supply and demand of labor.

Reforms should aim at enhancing work incentives. While the government has taken some measures to increase labor force participation (via reduced possibilities and incentives for early retirement, gradual increase in retirement age for women, reform of the unemployment benefits, and better control of sick leave), they are unlikely to be sufficient. Notably, half of the planned increase in women retirement age will be compensated by the regular ageing process. A faster increase in the retirement age for women (for instance by 6 months per year rather than the 3 months per year decided in 2010) to 65 and a further increase to 67 for all would help offset the impact of ageing and boost labor supply (in addition to reducing the deficit of the pension system). In addition, early retirement incentives remain too high. The penalty for early retirement (1.8 percent per year) is below the actuarially neutral level of 3–4 percent and should be increased to at least that level. Hungary, Spain and Italy have for instance a penalty of 5–6 percent per year. Also, reducing the tax exemption level for pension income to that of regular wage income would eliminate a distortion in favor of early retirement.
Measures should also be taken to reduce the tax burden on labor. The reduction of health contributions by 2 percentage points (with its revenue impact offset by an increase in VAT) in 2012, a so-called fiscal devaluation, is a step in the right direction and should help boost the demand for labor. The government could also consider increasing the zero VAT tax rate (which is not compatible with EU laws) to the 10 percent reduced rate (rather than 5 percent as currently envisaged). This would allow a further reduction in labor taxation. Raising property taxes could also help rebalance the tax structure away from labor in a revenue-neutral way, although the proceeds of such tax is likely to be low in the short-term given the need to first improve the land and property register.
Several changes in the Labor Law would reduce the hiring and firing costs, and notably: (i) relax the conditions for dismissal, notably for poor performance, for collective dismissal and for some categories of protected workers in case of justified business reasons; (ii) allow firms to opt out from onerous sector-level collective agreements; and (iii) decrease the maximum amount of compensation paid to a wrongfully dismissed worker from the current 18 months of salary to a more affordable 6 months.

35. Reforms to improve the business environment should aim at improving the legal and regulatory framework in order to increase investment. While some progress has been made since 2005, the time and costs of the procedures for dealing with construction permits and property registration remain significantly above the levels in Croatia’s peers. It is the time to register the new construction or property in the Land Registry that accounts for the longest delay (respectively 120 and 60/80 days). The planned digitalization and update of the land registry and cadastre should therefore be accelerated. Barriers to investment at the local government level should also be removed. Rules regarding the disclosure of conflict of interest as well as investor protection should also be improved. It is also urgent to strengthen the insolvency procedures and fasten the enforcement of judicial decisions. It takes about 50 percent more time to enforce a contract in Croatia compared to its peers due to long delay in the judicial system, while resolving insolvency takes about twice the time than in the OECD countries and the recovery rate is low (see Table 1). According to the 2011–2012 Global competitiveness report, the inefficient government bureaucracy is the most problematic factor for doing business in Croatia, while Croatia’s ranking in terms of the quality of its legal framework, protection of investors and minority shareholders and burden of regulation is at the very end of the index (111–137 out of 142) (Appendix Figure 6B).

Table 1.

Croatia Doing Business Indicators

^{^1.} Percent of 2006

Source: Doing Business report 2012, World Bank

Table 1.

Croatia Doing Business Indicators

		2012 as a percent of	Croatia as a percent of the regional average,	Croatia’s as a percent of OECD average,
Areas	Measures	2005	2012	2012
Starting a Business	Number of procedures	54.5	100.8	113.4
	Days required	24.1	43.0	56.2
	Cost as a share of income per capita	52.8	103.9	184.1
	Paid in minimum capital as a share of income per capita	54.1	128.4	97.9
Dealing with construction	Number of procedures	52.2	56.7	86.9
Permits¹	Days required	81.3	148.2	208.7
	Cost (% of income per capita)	60.6	124.7	1293.6
Registering property	Number of procedures	100.0	88.2	104.0
	Days required	10.9	348.9	339.4
	Cost (as a % of property value)	100.0	213.4	114.5
Protecting Investors¹	Extent of disclosure index (0–10)	100.0	14.5	16.4
	Extent of director liability index (0–10)	100.0	119.3	97.5
	Ease of shareholder suits index (0–10)	100.0	98.4	89.0
	Strength of investor protection index (0–10)	100.0	69.7	66.8
Trading across Borders¹	Documents to export (number)	100.0	99.3	160.7
	Days required to export	76.9	68.7	191.4
	Cost to export (US$ per container)	108.3	68.4	126.0
	Documents to import (number)	100.0	100.6	165.3
	Days required to import	88.9	51.0	148.9
	Cost to import (US$ per container)	98.3	55.2	108.8
Enforcing Contracts	Number of procedures	100.0	101.4	120.9
	Days required	100.0	143.4	108.3
	Cost (% of claim)	100.0	48.1	70.0
Resolving insolvency	Recovery rate (cents on the dollar)	103.1	88.8	43.6
	Years required	100.0	112.2	179.3
	Cost (% of estate)	100.0	119.3	164.9

^{^1.} Percent of 2006

Source: Doing Business report 2012, World Bank

Table 1.

Croatia Doing Business Indicators

		2012 as a percent of	Croatia as a percent of the regional average,	Croatia’s as a percent of OECD average,
Areas	Measures	2005	2012	2012
Starting a Business	Number of procedures	54.5	100.8	113.4
	Days required	24.1	43.0	56.2
	Cost as a share of income per capita	52.8	103.9	184.1
	Paid in minimum capital as a share of income per capita	54.1	128.4	97.9
Dealing with construction	Number of procedures	52.2	56.7	86.9
Permits¹	Days required	81.3	148.2	208.7
	Cost (% of income per capita)	60.6	124.7	1293.6
Registering property	Number of procedures	100.0	88.2	104.0
	Days required	10.9	348.9	339.4
	Cost (as a % of property value)	100.0	213.4	114.5
Protecting Investors¹	Extent of disclosure index (0–10)	100.0	14.5	16.4
	Extent of director liability index (0–10)	100.0	119.3	97.5
	Ease of shareholder suits index (0–10)	100.0	98.4	89.0
	Strength of investor protection index (0–10)	100.0	69.7	66.8
Trading across Borders¹	Documents to export (number)	100.0	99.3	160.7
	Days required to export	76.9	68.7	191.4
	Cost to export (US$ per container)	108.3	68.4	126.0
	Documents to import (number)	100.0	100.6	165.3
	Days required to import	88.9	51.0	148.9
	Cost to import (US$ per container)	98.3	55.2	108.8
Enforcing Contracts	Number of procedures	100.0	101.4	120.9
	Days required	100.0	143.4	108.3
	Cost (% of claim)	100.0	48.1	70.0
Resolving insolvency	Recovery rate (cents on the dollar)	103.1	88.8	43.6
	Years required	100.0	112.2	179.3
	Cost (% of estate)	100.0	119.3	164.9

^{^1.} Percent of 2006

Source: Doing Business report 2012, World Bank

36. More rapid privatization and enterprise restructuring would help foster competition. Privatization plans should be accelerated, including for the still unresolved shipyard companies, and a clear strategy put forward for liquidating or selling the assets owned by the Asset Management Agency. The launching of the restructuring of the railways company is welcomed and should be pursued further, while the electricity and gas markets should be liberalized further.

37. Fiscal consolidation efforts will need to be continued in the medium-term. Sustained fiscal consolidation will help improve the access and cost of financing both for public and private entities and will facilitate a reduction of the tax burden on labor, thereby encouraging higher investment.

38. Further efforts should be applied to raise government efficiency. The government’s intention to tackle corruption and implement a fiscal consolidation will help reduce wasteful and inefficient government spending. Government efficiency could be further improved by: (i) a rationalization of the structure of government operations, involving a comprehensive functional review of the size, functions and staffing of all government organizations; (ii) a reform of the salary formula to establish a tighter link between performance and salary, eliminate the seniority bonus and align wages at all levels of government; (iii) outsource non-core functions, such as transport, security, mail, cleaning, catering and maintenance to improve efficiency and generate fiscal savings.

F. Possible Impact of the Reforms

39. Quantifying the impact of structural reforms on growth is far from trivial. Most empirical studies find a positive long-term effect of labor and product market reforms on total factor productivity, growth and employment. However, the impact of the reforms varies widely as it depends on their specifics, the interactions between product and labor market institutions, the macroeconomic environment in which the reforms take place, and the timeframe as short-term effects may be smaller or even negative due to the cost and time of resources relocation and restructuring.

40. Calculations based on the growth accounting exercise conducted in Section A suggest that increasing participation rate and employment rate could help to lift GDP growth substantially. If Croatia’s participation rate were to increase in the next eight years to 70 percent as in the Czech Republic, GDP growth would increase by about 1 percent. This would in turn require an increase in investment to GDP ratio by 1 percentage point⁹.

41. Growth regressions show that in Croatia, structural reforms have the potential to increase economic growth significantly by improving productivity. Using the model in Vamvakidis (2008), increasing the economic freedom index to the level of Estonia (the best performer in emerging Europe) over the next five years would boost average annual growth by 0.9 percentage points.¹⁰ Reaching the average level of eastern European countries would boost growth by close to 0.4 percentage points. This would be mainly achieved by improving labor market flexibility and the efficiency of the legal framework and government spending, the areas where Croatia ranks the lowest. Moore and Vamvakidis (2007)¹¹ who have estimated a growth model for Croatia also show that improving the economic freedom index and the cost of starting new business to the average level of CEE countries, the euro area, or Ireland would increase average annual growth by about 0.4, 0.5, and 0.8 percentage points, respectively.

42. In addition, the impact of these reforms would be magnified by their impact on investment and FDI. If the investment to GDP ratio is increased from its current level of close to 22 percent to 25 percent¹² (the minimum level according to the Spence Report and also the average level in Slovakia, Slovenia, Czech Republic, Bosnia, Latvia in 2000–08), possibly through attracting more FDI, this would boost annual GDP growth by an additional 0.3 percentage points (the models in Vamvakidis (2008) and Moore and Vamvakidis (2007) give similar results).

43. The total impact of these reforms could be significant. While not all of these effects may be strictly additive and the quantification of the impact of structural reforms on growth is subject to large estimation errors, this exercise nevertheless suggests that the impact of structural reforms on GDP growth in Croatia could be substantial and exceed 2 percent in the medium to long-term.

Impact on medium-term annual growth rate

References: Vamvakidis (2008), Moore and Vamvakidis (2007)

G. Conclusions

44. Croatia’s pre-crisis growth model relied on capital accumulation in the non-tradable sector, which led to low productivity gains and export growth compared to its peers. Achieving reasonable medium-term growth requires a fundamental change in the economic policies and institutions.

45. The policy recommendations coming from the reviewed three sources of economic thought are very similar. To boost medium-term growth, Croatia needs to (i) increase work incentives to boost labor force participation and improve labor market flexibility, which will help the economy regain competitiveness and support export-led growth; (ii) improve business environment, via easier regulations, better legal framework, and more efficient administration, and foster competition by accelerating privatization and enterprise restructuring, to attract capital to the tradable sectors and boost productivity; and (iii) continue the fiscal consolidation efforts in the medium term to reduce macroeconomic risks and improve the access and cost of financing. Empirical evidences suggest that the impact of those reforms could be quite substantial, raising annual GDP growth by about 2 percent in the medium to long term.

Appendix

References

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International Bank of Reconstruction and Development (IBRD), 2008, “The Growth Report—Strategies for Sustained Growth and Inclusive Development” by the Commission on Growth and Development (Washington).
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Goldman Sachs, 2012, “Our 2011 GES: A sharper Signal for Growth”, Goldman Sachs Global Economics, Commodities and Strategy Research.
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Moore D. and Vamvakidis A., 2007, Economic Growth in Croatia: potential and constraints, IMF Working Paper No. 07/198 (Washington: International Monetary Fund).
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Prepared by Géraldine Mahieu.

The peer group of middle-income countries is defined as countries from Europe, Latin America, Asia, and Africa with a mid-level GDP per capita in PPP terms (between the one of Ukraine and Slovenia), plus Moldova. Very small countries and islands are excluded to contain the sample size.

Croatia’s GDP per capita growth rate averaged -2 percent over 2009–2011 compared to 0.7 percent in middle-income countries.

These estimates use a Cobb-Douglas production function with employment share calculated as the total wage bill over GDP ratio (leading to an employment share ranging between 0.4–0.5 depending on the years).

Following G. Mourre (2009), the growth accounting exercise assumes a constant share of labor of 65 percent while the net capital stock is constructed via the perpetual inventory method (with the capital stock over GDP assumed to be 2 in 1995).

The employment growth can be expressed as the combination of four factors: (i) population growth; (ii) growth of the working-age population; (ii) growth of the participation rate; and (iv) growth of the employment rate. Formally, total employment = population * (pop 15–64/population)* (labor force/pop 15–64) * (employment/labor force), with the three ratios being respectively the share of working population, the participation rate and the employment rate.

The decomposition using working age population for the crisis period is not possible due to missing data.

The full name is “The Growth Report—Strategies for Sustained Growth and Inclusive Development” by the Commission on Growth and Development, 2008, IBRD.

Assuming that the unemployment rate would remain broadly the same, this scenario would imply an increase in employment by about 19 percent. Assuming a constant capital to labor ratio, this would require an average increase of the capital stock by 2.2 percent per year, leading to an increase in investment to GDP ratio by 1 percentage point over these years.

The specification of his model is Real per capita GDP growth = 11.00 – 1.38* (log per capita GDP) – 7.05* (age dependency rate) + 0.13* (investment to GDP ratio) + 0.02* (university enrollment ratio) - 0.015* (inflation rate) + 0.07* (FDI ratio) + 0.59* (economic freedom) + 0.86* (change in economic freedom).

The specification of this model is Real GDP per capita growth = 0.98 +1.88* (dummy for SEE and CEE) - 0.49* (initial real GDP per capita) - 0.43* (population growth) + 0.14* (investment to GDP ratio) - 0.02* (inflation rate) + 0.001* (credit to private sector/GDP) + 0.43* (index of economic freedom) - 0.03* (cost of business start-up procedures in % of GNI per capita.

Achieving such a level in 8 years would require an average annual increase in the capital stock by about 2.4 percent and an annual increase in gross fixed capital formation by about 3.4 percent. In this scenario, the capital stock would increase by about 21 percent after eight years. Depending on the capital intensity of output, this could potentially generate further employment growth (above the one implied by the 70 percent participation rate), and thus even higher GDP growth.

Appendix

Prepared by Reginald Darius

The discussion of Croatia’s growth model follows the analysis of growth experiences in Eastern Europe detailed in Atoyan, R., 2010, “Beyond the Crisis: Revisiting Emerging Europe’s Growth Model,” IMF Working Paper 10/92 (Washington: International Monetary Fund).

Countries included in the analysis are Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Ukraine.

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Republic of Croatia: Selected Issues

Author: International Monetary Fund. European Dept.

Volume/Issue:: Volume 2012: Issue 303

Publisher:: International Monetary Fund

ISBN:: 9781475564488

ISSN:: 1934-7685

Pages:: 55

DOI:: https://doi.org/10.5089/9781475564488.002

Keywords
I. What Has Kept Croatia’s Growth Low and How to Boost it?1
References
- Appendix

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Middle-Income Countries: Change in Real GDP Per Capita, 2000–11, Annualized (percent)

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Growth beyond what is explained by convergence, 2000–2011, annualized (percent)

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Middle-Income Countries: Investment over GDP, 2000–2011

(percent)

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Middle-Income countries: saving to GDP ratio, 2000–2011 (percent)

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Structure of FDI Inflows

(Percent of GDP)

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Middle-Income Countries: labor force participation rate, 2009 (percent)

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Croatia - Structure of Investment, average 2004–2009

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Capital Inflows

(Percent of 2000 GDP; average of 2009–11)

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Croatia: EBRD transition indicators, 2000–2010

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Croatia: Relative growth performance, 2000–2011

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Middle-Income Countries: Growth Accounting, 2000–08

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Middle-Income Countries: Growth Accounting, 2009–11

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Middle-Income Countries: Employment Growth Decomposition, 2000–11

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Croatia: Education Level of the Labor Force

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Croatia: Openness to the global economy

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Croatia: Business Environment, 2011–12

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Croatia: Business Environment, Components, 2005–2012

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Croatia: Access to international financing, 2000–2008

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Croatia: Access to domestic financing

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Croatia and other Eastern European Countries: Structure of production by branches

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Croatia: Investment Structure¹

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EU and US: Average TFP growth by sectors, 95–2007, annualized (percent)

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Croatia: Cost of Finance, 2008–2011

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Croatia: Innovation performance

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Market Share, 2000–11

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