The Croatian authorities thank staff for very constructive policy discussions and their insightful analysis, with which they broadly agree. They believe that staff’s report rightly recognizes recent positive developments in the country, but also raises awareness about the fiscal vulnerabilities and remaining structural challenges. Despite the uncertainty ahead of parliamentary elections the authorities are keeping pace with reforms to address these challenges and accelerate the rebalancing of the economy.

Economic developments and outlook

After six years of recession, the Croatian economy has entered into positive territory at the turn of last year. The pace of economic contraction abated already in the second half of 2014 and the positive developments continued into the first quarter of 2015. However, the recovery is still very delicate as it mostly relies on external factors, primarily low energy prices, favorable financing conditions and stronger euro area growth. The internal demand is still very weak as the corporate sector debt overhang and balance sheet repair continue to weigh on investments. Private consumption, however, has picked up reflecting not only the lower oil prices, but also the income tax relief that was introduced at the beginning of the year. According to the latest labor market indicators it seems that the fall in employment is also bottoming out. CPI inflation has moved back into positive territory, partly on account of consumer food prices and the depreciation against the US dollar, which has mitigated the impact of low oil prices.

Looking ahead, the authorities assume that the growth will continue and further strengthen in 2016. Like staff, they also see that the additional fiscal consolidation, needed to bring the public debt under control, will continue to be a drag on growth. On the other hand, the external demand will remain strong and the contribution from domestic demand could also become marginally positive, if trends in private consumption continue and EU funds spur the recovery of investments. The authorities anticipate that the rebound in energy prices could push inflation higher, although it will remain well below its long-term average. The pick-up of growth is set to bring about a gradual reduction in unemployment. However, the risks to the outlook are substantial and tilted to the downside, especially in light of possible adoption of additional fiscal consolidation measures, worsening of the external environment and suboptimal use of EU funds.

Fiscal policy

The authorities share staff’s concerns about the fiscal vulnerabilities that have built up during the recession. In a difficult environment of economic contraction and low inflation, they have pursued fiscal consolidation in order to set the deficit below 3 percent of GDP by 2017 and stabilize the public debt trajectory. Moreover, the fiscal effort of 2.5 percent of GDP achieved in 2014 was somewhat stronger than the requirements under the Excessive Deficit

Procedure (EDP). However, despite these efforts, the general government deficit ended at 5.7 percent of GDP, much above the projected level, as revenues underperformed but also as the coverage was broadened with the adoption of European ESA 2010 accounting standards. These methodological changes affected the level of public debt, which reached 85 percent of GDP at end-2014.

In light of these developments, the authorities have reinforced their consolidation efforts for 2015. The Convergence Program that was submitted to the European Commission in April anticipates a fiscal effort of 1.5 percent of GDP, aiming for headline deficit of 5.0 percent of GDP. The European Commission has assessed that the proposed measures would probably yield a somewhat smaller structural adjustment, but has nevertheless confirmed that due to an over-achieving effort in 2014, the cumulative fiscal effort over 2014–2015 meets the target implied by the EDP requirements. The focus of consolidation in 2015 would be more on the expenditure than on the revenue side. Significant savings across different categories of expenditures, including subsidies and transfers, as well as across different levels of government, are expected. Capital investments, especially in the health sector, would also be rationalized and oriented more towards EU funding. The government plans to boost revenues mainly by withdrawing profits from SOEs, but also through increased excise taxes on tobacco and gasoline, and a recently introduced tax on interest earnings.

The fiscal consolidation in 2016 will focus on further rationalization of current spending to provide sufficient space for growth-enhancing expenditures. Tax compliance would be further enhanced, especially through strengthening of the tax administration. Regarding the property tax, the government will focus on the harmonization and better collection of local communal fees. More broadly, the consolidation process in the coming period will be underpinned by improvements in budget planning and expenditure control, as well as through strengthening of fiscal rules. In the authorities’ views, the implementation risks to their consolidation plan are relatively contained, especially given the realism in growth and revenue projections, and their engagement in the enforcement of savings. Risks stemming from the accumulation of arrears in the health sector are also being addressed through comprehensive reforms, including tighter cost control and a new management model.

Monetary policy and financial system

In the context of widespread euroization and sizable foreign currency exposure of both private and public sector, maintaining exchange rate stability is instrumental in preserving both macroeconomic and financial stability. The monetary authorities remain strongly committed to this goal, as the contractionary impulse from a revaluation of FX-indexed debts and its impact on the financial system would outweigh any stimulus for the tradable sector. While preserving exchange rate stability, the monetary policy has maintained its accommodative stance, creating favorable financing conditions and supporting the credit activity.

Mainly thanks to sound macro-prudential regulation the banking sector has been coping well with the prolonged recession. The banks are well-capitalized, with an adequacy ratio over 21 percent, much above the required minimum. Their profitability has also improved over the last year, and NPLs have stabilized at around 17 percent. However, a weak macroeconomic outlook and uncertainty over the outcome of negotiations related to Swiss Franc-indexed loans remain the most important risks for the performance of the banking system. Against this background, the authorities are actively engaged in finding a socially acceptable solution which would not jeopardize the financial stability and legal certainty.

The existing external vulnerabilities require adequate reserve buffers and the authorities continue to be dedicated to enhance them. In the authorities’ view the current level of reserves is adequate. Having in mind recent efforts to reform the RAM framework with the aim to capture country specifics in a more comprehensive way, one should not assess reserve adequacy solely on the basis of RAM metric’s results. Hence, the authorities point to a few country specifics which ought to be taken into account while making an overall assessment of the reserve adequacy. The first is related to the CNB’s macro-prudential regulation, under which the commercial banks in Croatia are prescribed to hold minimum required foreign currency claims (MRFFC), which serve as a complement to the central bank’s reserves. The second factor is related to a sizable affiliated bank debt and FDI-related short-term liabilities, which are both known to be a more stable source of funding, and which serve as a mitigating factor against risks of capital outflows. If the aforementioned two factors would be accounted for, the RAM coverage for Croatia would increase by some 30 percentage points up to the adequacy requirement limit.

Structural reforms and competitiveness

Despite recent improvements, Croatia’s export sector is clearly lagging behind its peers and lacks competitiveness. In search for underlying factors, staff finds that the REER is modestly overvalued based on the results in the range from -2.8 to 10 percent. The upper bound of this range comes from the comparison of unit labor costs, while the two standard methods of ER assessment - CGER and EBA (in the range from -2.8 to 5.8) - clearly indicate that the REER is broadly in line with fundamentals. With such ambiguous results and minor deviations from the equilibrium, the authorities would not expect a conclusion on the exchange rate overvaluation. Also, unlike CGER and EBA, the results based on the comparison of unit labor costs are subject to arbitrariness in sample selection and data sources, and are usually not taken as a benchmark for ER assessment in IMF country reports. In that regard, evenhandedness in the application of the ER assessment methodology is warranted.

The authorities attribute the export underperformance more to non-price structural factors. In response, they have embarked on an ambitious structural reform agenda, with the emphasis on the business climate, labor market flexibility, debt restructuring and public sector reform. Significant improvements have already been made in some areas. The second phase of the labor market reform was fully implemented, resulting in lower costs of work force restructuring and increased flexibility of working hours. The pre-bankruptcy settlement procedure is also being strengthened with the objective to facilitate earlier access to the debt restructuring process. The consumer bankruptcy act is currently in the parliamentary procedure.

In the context of the business environment, the authorities are further reducing para-fiscal charges for the private sector. The restructuring of SOEs has progressed and now the governance issues are being tackled through professionalization of management, which should underpin the ongoing privatization endeavors. Streamlining of social benefits and tightening of special pensions should support the chronically low labor market participation.

Despite these efforts, the Croatian authorities see that their reform agenda has only recently started to bear fruit. Now, that the economy has finally bottomed out, there should be more space and broader public support to push the reform agenda further. They understand that structural reforms are key to increasing competitiveness and unlocking the growth potential.