The Croatian authorities highly appreciate the constructive policy dialogue with the IMF mission during the 2016 Article IV Consultation, and thank staff for the appraisal and policy recommendations. They also welcome the staff analyses in the Selected Issues paper. The authorities are committed to prudent macroeconomic policies which properly address vulnerabilities in line with the country specifics and promote sustainable growth. They believe that the policy discussions with the Fund will help to set the appropriate policy mix needed to strengthen the economic recovery and achieve goals of the Government’s National Reform Program (NPR) presented in May.

Recent economic developments and outlook

Staff and the authorities share views on the recent developments, outlook and risks. The economy has finally bottomed out in 2015, which is expected to strengthen public support for the reform agenda. The recovery has gained some more traction in Q1 2016 when GDP growth reached 2.7 percent y-o-y. Growth also becomes more broad-based since all the elements of final demand have registered a positive contribution for the first time in many years. Exports grew by 7.1 percent y-o-y, gross fixed capital formation by 4.3 percent, personal consumption by 3.1 percent, and the government consumption by 0.6 percent. In April, adjusted industrial output was up by 4.9 percent y-o-y and retail trade growth was positive for the 21st consecutive month, with nominal sales growth at 0.7 percent y-o-y.

The recovery of economic activity in 2015 and early 2016 reflected a favorable labor market. The positive trends will continue, although at slower pace, along with projected employment growth and a decreased unemployment rate. The number of unemployed declined and is trending below the 2015 minimum ahead of the peak of the tourist season. Despite unfavorable demographic trends, economic recovery will also have certain positive effects on the rate of labor force participation.

Fiscal policy and debt management

Like staff, the authorities see that growth recovery provides an excellent window of opportunity to progress with the additional fiscal consolidation and debt restructuring, successfully exit from the EU’s Excessive Deficit Procedure, and put the public debt on a sound footing over the medium term. In line with macroeconomic projections for the period 2016-19, and based on the implementation of structural reform measures, the fiscal consolidation strategy of the new government launched with the NRP aims to reduce the planned budget deficit on a consolidated basis to 1 percent of GDP in 2019. These positive trends regarding the significant reduction of the budget deficit, and taking into account the privatization incomes and a change of government deposits, will lead to a reduction of the public debt to GDP ratio in 2016 to 85.9 percent, after several years of strong increase. It is expected that the public debt to GDP ratio will be gradually reduced to 80 percent of the GDP by 2019.

A balanced approach to the fiscal consolidation for the 2016-2019 is envisaged, including measures on both the revenue and expenditure side in order to minimize the negative impact on growth. The recently updated NRP presents in details the key fiscal reforms which are focused on: (1) introduction of a modern real estate tax by January 2018; (2) reform in public administration by making part of public servants’ compensation performance-based; (3) streamlining social benefits; (4) reforming the pension system; and (5) activation of state property. The NPR implementation, however, requires important legislative changes and in the current domestic political juncture, and some more time is needed to build the necessary consensus to reforms. In line with that, the largest structural measure in 2016 on the revenues side is to further enhance the tax system and strengthen the tax administration, while implementing the required improvements in land registration and the cadaster to lay ground for successful introduction of the property tax in January 2018. On the expenditure side, the fiscal consolidation in 2016 will focus on further rationalization of current spending to provide sufficient space for growth-enhancing expenditures in the medium term. The government is advancing with the introduction of performance based public servants’ compensation scheme.

In consultation with the European Commission, a new Fiscal Responsibility Act is proposed to strengthen the independence of the existing Fiscal Policy Committee and ensure the full compliance of national fiscal rules with the relevant EU framework. Among other things, the Act establishes mechanisms for compliance and the sanctioning of non-compliance with the planned budget limits for all the layers of the government. Adoption of the Act is planned by September 2016.

Monetary policy and financial stability

The monetary authorities remain firmly committed to exchange rate stability as a proven policy anchor for inflation expectations and financial stability. This exchange rate regime has served the country well and the authorities welcome staff recognition in this regard. They agree with staff that gradual de-euroization would be desirable. However, irrespective of the authorities’ continuous efforts to increase the attractiveness of savings in domestic currency, including maintaining the positive interest differential on domestic currency deposits and informing the public about potential risks of FX borrowing, deposit euroization has remained deeply entrenched against the background of past episodes of monetary instability in the 1980’s and early 1990’s.

In the given environment, the monetary authorities have managed to maintain a highly accommodative monetary policy stance, thus creating favorable financing conditions for all domestic sectors and supporting the economic activity. Since the beginning of the year, banks’ credit activity has started to recover following a pick-up in economic activity. In particular, credit to the corporate sector increased by 3.8 percent in the first four months of this year. An accommodative stance was further strengthened with the introduction of a new instrument: a four-year structural reverse repo facility, which provides banks with long-term funding in local currency. Although still high, the NPL’s started declining, and their provisioning increases, reaching almost 60 percent thanks to the earlier CNB policies. The planned changes in the tax treatment of write-offs, as outlined in the authorities’ NRP, could additionally help the swifter unwinding of the banks’ stock of NPLs, as well as, the reinforcement of the pre-insolvency and insolvency frameworks for businesses and adopting a personal insolvency procedure.

Concerning the international reserves, the authorities agree that the existing external vulnerabilities require adequate buffers and they continue to be dedicated to their enhancement. However, they emphasize that aside from the CNB’s international reserves, the commercial banks also hold an additional buffer in line with the CNB’s prescribed macro-prudential regulation. When these two are taken together, Croatia’s reserve buffer is comfortably in the recommended range of 100-150 percent of the IMF’s RAM metric. The sizable share of affiliated bank debt and FDI-related short-term liabilities in total debt liabilities also serves as a mitigating factor against risks in times of financial distress. Nevertheless, CNB remains open to look further for opportunities to continue accumulating international reserves, as was the case in May 2016, when 84 million euros were purchased through the FX interventions.

The Croatian banking system continues to demonstrate high resilience thanks to the solid fundamentals and sound macroprudential policies of the CNB. The system-wide capital adequacy ratio remains robust, close to 21 percent at end-2015. In 2015, the profit and loss accounts of banks were temporarily, but strongly affected by the legislative amendments aimed at facilitating the position of debtors with loans in Swiss francs and with foreign currency clauses in Swiss francs. Banks’ operational profitability was, however, even slightly higher than a year before. As a result of that operation, the total capital adequacy ratio declined by 0.5 percentage points compared to the end of 2014.

Competitiveness and structural reforms

The Croatian authorities are well aware that the productivity-enhancing fiscal and structural reforms are essential to improving competitiveness. Starting from the premise that the public administration reform is a key prerequisite for creating a supportive institutional framework for the implementation of all relevant reforms, the government is taking steps to improve the efficiency of the public sector, while reducing overlaps between different layers of the administration, improving the management practices and revising the wage policy.

The restructuring and preparation for privatization of the state-owned enterprises is also progressing. The government is redefining their policy on public companies by setting harsher requirements on the quality of operations, planning and realization of business objectives, and improving operational control to facilitate ongoing privatization endeavors. In particular, the government is examining the justification of ownership over companies of strategic interest in order to reduce their number. Privatization of the government minority stockholdings is also being stepped up. As part of these efforts, in May 2016, 20.4 percent of the government shares in electronic industries Končar were sold to the institutional investors.

A comprehensive set of measures to streamline social benefits, reform the pension system, and improve the healthcare system is also being considered. Significant progress has been made with regards to the establishment of a single center for social welfare benefits with integrated data and benefit administration (one-stop-shop). Measures to encourage a longer working life and increase penalization for early retirement are also considered. The government also seeks a consensus to implement the necessary changes in the primary healthcare and health insurance system, emergency medicine reform, and hospital network reorganization, including rationalization and reorganization of non-medical services in the hospitals. In the context of improving the business environment, the authorities are re-examining the para-fiscal charges for the private sector. Despite the many challenges ahead, the Croatian authorities are confident that these measures will help improve competitiveness, and pave the road to sustainable and more inclusive growth.