The Croatian authorities thank staff for the constructive and candid dialogue during their mission in Croatia. They appreciate staff’s comprehensive and objective analysis of the macroeconomic situation and agree with their assessments and policy recommendations. Policy discussions have helped the authorities to set the right policy mix needed to support the economic recovery.

Economic developments and outlook

The Croatian economy has been in recession for five consecutive years. In 2013, GDP contracted by 1 percent, as domestic demand remained depressed by high unemployment and private debt overhang. The annual inflation slowed to 2.2 percent, and the declining commodity prices in the global market are likely to keep it subdued going forward.

The export performance has also been weak, reflecting structural weaknesses and adverse economic developments in the main trading partner countries. Also, exporters have still not taken full advantage of the EU membership, while the access to the traditional CEFTA markets has become more difficult after the EU accession. With large adjustments on the imports side over the last few years, the current account ended in surplus of about 1 percent of GDP in 2013. Previous imbalances, however, have hiked external debt in excess of 100 percent of current GDP.

With respect to the GDP forecast for 2014, the authorities are somewhat more optimistic than staff. Recent data show that the decline bottomed out in the second half of 2013 and high frequency data point to modest recovery in the first quarter of 2014. The structural reforms and debt restructuring will moderate the current negative trends, although the necessary fiscal consolidation will dampen the growth prospects in the short term. Looking forward, the gradual economic recovery will be based on the restoration of investment, financed largely through the EU funds, and the improvement in export of goods and services as the economy catches up in terms of competitiveness.

Fiscal policy

The prolonged recession has led to deep fiscal imbalances. Despite the government’s consolidation efforts, the budget deficit remained high in 2013, contributing to a significant increase in public debt. Apart from the weak economic activity, the EU accession initially had a negative impact on the budget (revenues from custom duties were permanently lost, VAT collection was delayed, and the membership fee was paid). However, a positive impact of the EU membership on the budget will take place in the coming years when the EU funds bring positive growth effects. The overall fiscal discipline and tax collection have improved, due to a series of measures, including the introduction of the Fiscal Cash Register Act. Budget expenditures increased in 2013 due to the settlement of arrears in the healthcare sector and fiscal transfer to the EU budget. This was partly offset by nominal savings in most categories of expenditures, including the public wage bill and subsidies to companies.

In January 2014 the Council of the European Union opened the excessive deficit procedure (EDP) for Croatia, as the budget deficit and the public debt at end-2013 were above the reference values. The Council’s recommendation was to impose structural measures in the amount of 2.3 percent of GDP in 2014 and 1 percent of GDP in both 2015 and 2016 in order to achieve the targeted levels of deficit. The Croatian authorities are committed to comply with these recommendations, despite a negative short-term impact of strong fiscal adjustment on economic activity. The EU policy framework will help to enhance fiscal governance and growth prospects, which will ensure fiscal sustainability and improve the financing conditions. To this end, the state budget was revised in March 2014, containing a comprehensive set of structural consolidation measures in the recommended amount.

In order to minimize the negative impact of strong fiscal consolidation, a balanced approach including measures on both the revenue and expenditure side is envisaged as the consolidation plan for 2014-2016. The largest structural measure in 2014 on the revenues side is restoring the rate of the compulsory health insurance contribution to 15 percent. Later on the authorities plan to introduce a tax on interest earnings and a property tax. They will also continue with the activities aimed at increasing fiscal discipline and tax collection. Measures on the expenditure side will aim at rationalizing the current expenditures, while maintaining adequate social protection and capital spending partly supported by the EU funds. Better targeting of social transfers and further rationalization of capital transfers is also envisaged.

Monetary policy and financial system

The monetary authorities continue to be firmly committed to maintaining exchange rate stability. This policy provided an anchor for inflation expectations and financial stability in the context of widespread euroization. In view of the sizable foreign currency exposure of both the private and public sector (150 percent of GDP), even a moderate exchange rate depreciation would cause strong negative balance sheet effects and credit losses. Though one can find Croatia’s monetary policy constrained, it is important to note that such an exchange rate regime has been determined by specific economic circumstances, and has served the country well. Moreover, the benefits to competitiveness from a more flexible exchange rate (even if it would be possible) are uncertain in case of a small and open economy such as Croatia. Regardless of the exchange rate regime, the productivity enhancing fiscal and structural reform policies are essential to fix the competitiveness problem, and there is simply no alternative to that.

Such an exchange rate regime, combined with high euroization and the existing external vulnerabilities, requires adequate reserve buffers. The central bank has been steadily increasing international reserves over time, also during the recent times of lower capital inflows, and considers the current level of reserves adequate. With regards to the reserves adequacy matrix, international reserves currently exceed the amount of reserve money by a large margin (close to 160 percent) and cover more than 8 months of imports. The short-term debt coverage is somewhat lower (around 90 percent) than the IMF metric, but if intercompany bank debt and FDI-related short-term liabilities, which are significant in Croatia and have proven to be relatively stable, are excluded, then the coverage reaches 160 percent. Nonetheless, the central bank will continue to gradually accumulate reserves, depending on capital flows dynamics and in line with the underlying exchange rate policy.

The Croatian banking system continues to demonstrate high resilience, despite previous adverse external shocks (both the U.S. subprime crisis and the euro area crisis) and a 5-year long domestic recession, mainly thanks to sound fundamentals and macroprudential measures implemented in the pre-crisis period. The system-wide capital adequacy ratio remains robust, currently close to 21 percent, and is adequate. It can also hypothetically sustain the entire NPL’s write-off (net of provisions), and still remain at about 12 percent. With regard to banks’ profitability, although headline figures are pointing to a decline in profitability over the last year, banks’ operational profitability on average has not changed at all, which can be explained by a more active provisioning policy encouraged by the central bank. Thanks to that, during 2013, the coverage of NPLs by specific loan-loss provisions increased by almost 4 percentage points to 46 percent, and it is expected that with such a provisioning policy in place, loan-loss provisions of the Croatian banking system will reach those of its peers on average over the next two years.

Competitiveness and structural reforms

Staff’s assessment of Croatia’s real effective exchange rate points to a 10 percent overvaluation. The authorities, however, would like to point to methodological shortcomings of their approach (the comparability of the data and the countries in the sample can be questioned). The authorities’ own calculations, based on the application of the same methodology for a more comparable set of countries (EU member states), suggest a range from 2 percent overvaluation to 8 percent undervaluation. Therefore, no strong conclusion on the exchange rate misalignments could be made.

Nevertheless, Croatia’s competitiveness position is weak, although continuous improvements in the price-competitiveness became apparent in recent years, particularly in REER deflated by nominal unit labor costs. Regardless, Croatia is lagging behind in export performance, which is evident in the persistent erosion of market share of Croatian exporters on the world market. The underlying factors are not clear, while relative prices and costs might play a role, other non-price factors may be even more important. Some of these factors are long-existing structural problems, like the unfavorable product specialization and geographic orientation, labor market rigidities, weak business environment, and other bottlenecks that discourage investments (both domestic and foreign) and deter exports.

In this respect, the Croatian authorities see the need for a fast implementation of structural reforms to tackle the lack of competitiveness. They have already addressed some areas. More direct support is being provided from the central government to foreign direct investors to help revive FDI inflows. The pre-bankruptcy settlement procedures are being intensified, bringing debt relief to companies, and similar measures are being developed to help over-indebted households. As noted in the National Reform Program that was published in April 2014, the authorities will proceed with the restructuring and privatization process, prioritizing on the transportation sector. A comprehensive set of measures to improve the healthcare system and increase the labor market flexibility is also being implemented. Despite the many challenges ahead, the Croatian authorities believe that these measures will help improve competitiveness, and pave the road to sustainable and more inclusive growth.