Republic of Croatia: Staff Report for the 2017 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
16 Jan 2018
eISBN:
9781484337325
ISBN:
9781484337325
Language:
English
Keywords:
ISCR; CR; preliminary information; staff appraisal; IMF staff estimate; IMF staff calculation; Recent IMF staff analysis; exchange rate; broad money; Recent IMF staff research; Nonperforming loans; current account
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2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of Croatia

Abstract

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of Croatia

Context

1. Croatia’s recovery continued into a third year after a prolonged recession. Over 2015–16, real GDP growth averaged 2.5 percent, reflecting strong tourism and private consumption, trade partners’ growth, higher absorption of EU funds, and improved confidence (Figure 1, Tables 1–2). Sizable fiscal consolidation since 2014 allowed Croatia to exit the EU’s Excessive Deficit Procedure (EDP) in June 2017. Croatia’s GDP per capita now stands at about 60 percent of the EU average.

Figure 1.
Figure 1.

Selected Real Sector Indicators, 2012–17

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: Croatian Central Bureau of Statistics; Croatian National Bank; and IMF staff calculations.1/ 6 months rolling average.
Table 1.

Croatia: Selected Economic Indicators

article image
Sources: Croatian authorities; and IMF staff estimates.

Includes state-owned enterprises.

In percent of potential GDP, excluding capital transfers to public enterprises and one-off invetment retrenchment in 2015.

Comprises claims on households and non-financial corporations.

Weighted monthly average of daily interest rates for auctions of Treasury bills issued by the Ministry of Finance.

Table 2.

Croatia: Medium-Term Baseline Scenario

(Percent of GDP, unless otherwise indicated)

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Sources: Croatian Central Bureau of Statistics; Croatian National Bank; Ministry of Finance; and IMF staff estimates.
uA01fig01

EU CESEE: Real GDP Growth /1

(In percent)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

1/ EU CESEE : Central, Eastern, and Southeastern European countries include Bulgaria, Czech Repub Estonia, Hungary, Lithuania, Latvia, Poland, Romania, Slovenia and Slovakia.Source: IMF, World Economic Outlook.

2. The main challenge is to transform the current momentum into high sustainable medium- and long-term growth. Croatia’s output, employment, and total factor productivity remain below their pre-2008 levels. Income convergence with the EU has slowed after the global financial crisis (GFC) for various reasons, including delays in implementing structural reforms (Annex I). The balance of risks facing the economy has improved, but vulnerabilities remain significant. Supporting faster income convergence, while reducing vulnerabilities, will require growth-friendly fiscal measures and productivity-enhancing structural reforms.

uA01fig02

Growth Differential Before and After the Global Financial Crisis

(Difference in average PPP GDP per capita growth with Germany)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: World Bank Development Indicators; and IMF staff calculations.

Recent Developments

3. The economy is estimated to be operating close to potential. The output gap appears to be closing. However, although unemployment has declined from its post-GFC highs, it remains elevated (11.6 percent at end-October 2017) and, in staff’s view, seems mostly structural. Labor supply continues to be affected by unfavorable demographics, emigration, untargeted social benefits, and rigidities in the labor market. Wage pressures are still moderate and inflation is low.

uA01fig03

Survey Unemployment Rate

(Percent)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: Eurostat; and IMF staff calculations.
uA01fig04

Real Wage Growth

(Year-on-year percent change, non-seasonally adjusted)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Source: Haver.

4. Large fiscal consolidation has been achieved over the past few years (Figure 2, Table 3). There was a significant fiscal overperformance once again in 2016, with the deficit at 0.9 percent of GDP compared to the budget target of 2.6 percent. This mainly reflected stronger-than-projected tax revenue and an effective freeze of expenditures other than those related to EU funds. The structural deficit improved by close to 2 percent of potential GDP and public debt fell to about 83 percent of GDP (Annex II). Refinancing needs were met on very favorable terms as Croatia’s risk premium declined significantly.1

Figure 2.
Figure 2.

Fiscal Developments and Projections, 2012–22

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: Croatian authorities; and IMF staff estimates.
Table 3.

Croatia: Statement of Operations of General Government

(Percent of GDP, ESA 2010)

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Sources: Eurostat; and IMF staff estimates.

Mostly EU structural and investment funds.

Non-capital transfers financed by the EU structrual funds and national co-financing.

Data in 2016 are preliminary and subject to revisions.

In percent of potential GDP, excluding capital transfers to public enterprises and one-off investment retrenchment in 2015.

uA01fig05

Bond Yields

(Percent)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Source: Bloomberg.

5. Domestic monetary conditions remain accommodative and banks’ financial positions have strengthened. Intrabank liquidity is ample and money market rates are at modest levels (Figure 3). Although the continuing widespread deleveraging resulted in a negative overall credit growth, transaction data indicate that bank lending began to pick up in mid-2016 (Table 4). Furthermore, the share of kuna lending, particularly to households, has been increasing gradually since 2015. The banking sector remains on average well capitalized and liquid, and profitability has been bolstered by lower provisions, one-off items, and a modest increase in net interest income (Table 5). The still high NPL-to-total loans ratio has been declining. The Agrokor crisis has not reversed this trend, but slowed it down. NPLs are well- provisioned, and the un-provisioned part is, on average, fully covered by capital exceeding the minimum requirement.

Figure 3.
Figure 3.

Monetary and Banking Sector Developments, 2012–17

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: National Bank of Croatia; and IMF staff estimates and calculations.1/ Reserves are a 3-month moving average, in billions of kuna.2/ Based on change in stock of credit.
Table 4.

Croatia: Monetary Accounts

(End of period, billions of Kuna, unless otherwise indicated)

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Sources: Croatian National Bank; and IMF staff estimates.Note: As of January 2015, the Croatian National Bank started publishing monetary statistics in line with ESA 2010.

Comprises claims on central government and funds, and local government and funds, net of their deposits in the banking system. Central government funds include the Croatian Bank for Reconstruction and Development (HBOR).

Comprises claims on households and enterprises. Excludes other banking institutions (household savings banks, savings and loan cooperatives, and investment funds) and other financial institutions.

Excludes statutory reserves in foreign currency.

Quarterly annualized GDP is the sum of nominal GDP the last four quarters, not seasonally adjusted.

Transaction data exclude the effects of exchange rate changes, securities price adjustments and write-offs, including sale of placements in the amount of their value adjustments.

Table 5.

Croatia: Financial Soundness Indicators

(Percent, unless otherwise indicated)

article image
Source: Croatian National Bank and the IMF’s Financial Soundness Indicators.Note: The classifications used in the table are consistent with the IMF’s Financial Soundness Indicators Database.

Assets include gross loans, interbank loans, investment portfolio of banks, total interest income, total off-balance sheet claims.

Total loan-loss provisions in percent of gross loans as defined by the Financial Soundness Indicators.

Liquid assets are on a net basis. They include deposits at banks and at the central bank, short-term government and central bank paper, and overnight loans extended; less required reserve funds, central bank loans received, and overnight loans received.

uA01fig06

Bank Claims on Private Sector

(Annual percentage change)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: Croatian National Bank and IMF staff estimates.Note: Claims on private sector include claims on households, non-financial corporations, and local governments. The decline in late 2015 is partially explained by the conversion of Swiss franc-indexed household loans into euros.1/ Dotted line is based on transaction data, i.e. adjusted for exchange rate changes, sales and write-offs of NPLs. For details, see Annex 1 in CNB Monthly Bulletin No. 221, February 2016, Croatian National Bank.

6. The external position remains broadly in line with fundamentals. Tourist arrivals have been increasing steadily, reflecting both adverse geopolitical conditions in competing destinations and efforts to increase capacity and expand the tourism season (Figure 5, Table 6). Merchandise exports growth moderated, but remained buoyant. Croatia continued to gain market share in the EU since its entry in mid-2013. External debt declined further, and the real exchange rate remained broadly in line with fundamentals (Annexes III and IV). However, non-price indicators continue to suggest broader competitiveness challenges. The Croatian National Bank (CNB) made foreign exchange purchases in 2016, but gross international reserves declined slightly by year-end due to the abolishment of the requirement for banks to maintain part of their statutory reserves in FX with the CNB. Moderate upward exchange rate pressures continued throughout most of 2017, and the CNB has been accumulating sizable reserves.

Figure 4.
Figure 4.

Financial Market Developments, 2012–17

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: Bloomberg; Croatian National Bank; and IMF staff calculations.
Figure 5a.
Figure 5a.

Balance of Payments, 2012–16

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: Croatian National Bank; and IMF staff estimates.1/ MLT loans -Medium and long-term loans.2/ Other investments consists of the of currency and deposits, loans, short-term capital flows, medium and long-term flows, and trade credits.
Figure 5b.
Figure 5b.

Tourism

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: Eurostat; Croatia statistical office; Croatian National Bank; and IMF staff calculations.
Table 6.

Croatia: Balance of Payments

(Millions of euros, unless otherwise indicated) 1/

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Sources: Croatian National Bank; and IMF staff estimates.

Based on BPM5.

Since end-2008, external debt is reported based on the new reporting system (INOK).

uA01fig07

CESEE EU: Change in Export Market Share

(Percent)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Source: European Commission.
uA01fig08

Kuna per Euro and FX Interventions

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Source: Croatian National Bank.

Outlook and Risks

7. Growth is expected to gradually decelerate over the medium term. Growth is projected to reach 3.1 percent in 2017, mostly due to strong tourism and private consumption. Investment has been lagging but is envisaged to increase in the near term as the absorption of EU structural and investment funds improves and overall deleveraging (on stock basis) gradually comes to an end. The strong current account surplus—projected at 3.7 percent of GDP in 2017—is expected to steadily decline as export and tourism growth moderates. Inflation is envisaged to slowly pick-up but to remain low and in line with regional trends. Growth is projected to converge towards 2 percent by 2022, mostly due to structural impediments (Annex V).

8. While the balance of risks has improved, it remains tilted to the downside over the medium term (Annex VI).

  • ➢ Upside risks include: (i) more favorable conditions in trading partners, which could spill over into higher exports; (ii) lower GDP and employment compared to pre-2008 levels may point to more cyclical slack; and (iii) the recent history of fiscal overperformance could contribute to increased confidence and activity.

  • ➢ Downside domestic risks are mostly related to Agrokor. There is a risk that in 2018 the Agrokor restructuring could have a higher-than-expected impact on domestic investment, export capacity, and consumption (Annex VII).2 Private consumption may slow down if there are significant layoffs in the affected companies, and this could also reduce tax revenue and increase unemployment benefits. At 80 percent of GDP, public debt is still high and subject to currency and interest rate risks. Financing needs also remain elevated, and the debt path over the medium term is vulnerable to growth shocks and the materialization of contingent liabilities (Annex II).

  • ➢ Regarding downside external risks, a sudden tightening in global financial conditions could put pressure on public finances and borrowers with variable rate loans. Corporate balance sheet FX mismatches are the highest in the region. Furthermore, despite the recent progress in reducing euroization of banks’ balance sheets, it remains high.3 Vulnerability, especially of unhedged borrowers, could, therefore be substantial in case of significant exchange rate volatility.

uA01fig09

Contribution to Growth

(Percent)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Source: Croatian Central Bureau of Statistics.
uA01fig10

Sectoral Net FX Balance Sheet Exposures /1

(In percent of GDP, December 2016)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

1/ Calculated as foreign currency assets less foreign currency liabilities of each sector based on reporting by domestic depository institutions, BIS banks and data on outstanding foreign currency debt instruments.Sources: Regional Economic Issues (IMF April 2017) based on IMF Monetary and Financial Survey Database; IMF Vulnerabilities Exercise Securities Database; BIS Locational Bank Statistics; World Economic Outlook database; and IMF staff calculations.

Authorities’ Views

9. The authorities project slightly stronger growth over the short- and medium-term, based on the assumption of higher private consumption and investment. They consider the risks to be broadly balanced. While investment by companies in the Agrokor conglomerate has been affected by its debt crisis, the authorities expect its restructuring to proceed in an orderly manner thanks to the adoption of the new law on systemic companies. The caretaker management’s plan envisages the impact on employment to be minimal as Agrokor’s core companies are broadly sound, and intends to offer creditors debt-to-equity swaps rather than cash repayment from their sale. The authorities believe that this approach is less likely to result in an imminent downsizing and job loss. They noted that the banking system has thus far withstood well the Agrokor crisis and are confident that it will be able to withstand further write-offs that may arise from the conglomerate’s restructuring, as indicated by the CNB’s stress tests.

Policy Discussions

A. Fiscal Policy: Utilizing the Upturn

10. A small fiscal deficit is expected for both 2017 and 2018. Staff projects the 2017 general government deficit at about 0.6 percent of GDP, well below the budget target of 1.6 percent. This overperformance is due to robust cyclical revenues, lower than budgeted interest payments, and ongoing tax administration reforms that helped mobilize revenues and contain the expected losses from recent tax cuts (Annex I). Virtually all expenditures were executed as planned, including the wage increases.4 Nonetheless, staff estimates that the cyclically-adjusted balance deteriorated by about 0.2 percent of potential GDP, pointing to a mildly procyclical fiscal stance. The 2018 budget is targeting a deficit of 0.5 percent of GDP. The authorities’ plan further consolidation towards a small surplus starting in 2019.5 Staff believes that the 2018 target is feasible and that a small surplus could be achievable starting 2020. This would lead to a reduction in public debt to about 65 percent of GDP. Such a scenario is feasible within current policies. It is, however, contingent on resisting political pressure for a rapid reduction in taxes or raising expenditure, including for further increases in benefits for war veterans and public wages.6

11. Given the current positive growth dynamics, and existing debt vulnerabilities, staff advocated a faster reduction in public debt over the medium term. This would help reduce the government’s financing needs, cushion the effect of any tightening of global financial conditions, and create additional fiscal space that can be used during future downturns. The size of the recommended additional adjustment is guided by (i) adopting a mildly counter-cyclical fiscal policy that would preserve the ongoing recovery, and (ii) bringing debt below 60 percent of GDP by the end of the medium term, which would also be in line with the Stability and Growth Pact’s threshold. To achieve these two objectives, staff recommended implementing additional cumulative measures of 1.5 percent of GDP during 2018–22. This would result in a sizable reduction in debt over the 5 years of around 20 percent of GDP.

Recommended Fiscal Savings, 2018–22

(In percent of GDP)

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12. To achieve the recommended fiscal consolidation, while supporting activity and job creation, staff advocated the following improvements in the structure of both revenues and expenditures over the 2018–2022 period:

  • ➢ On the revenue side, staff estimates that adopting a modern real estate tax could generate additional revenue of around 1 percent of GDP. A well-designed real estate tax that is based on objective criteria would be more equitable and would yield more revenue than the existing communal fees. This revenue would allow for a further reduction in less growth-friendly taxes, such as income taxes. Staff also sees room for further streamlining the VAT rates in line with the original VAT reform proposal, while ensuring that the measures are revenue neutral.7

  • ➢ On the expenditure side, staff encouraged the authorities to build on, and implement, the measures contained in the Convergence Program and the NRP. In particular:

    • Social benefits could be reduced by 1 percent of GDP while protecting vulnerable groups. Currently, there is no strategy to coordinate the different types of social benefits (which are provided by 7 different ministries and vary between municipalities) and there is a clear need to improve targeting. Staff recommended that the social benefits reform be designed in consultation with the World Bank and focus on better targeting and monitoring, including through reviving the plan to introduce a one-stop shop for benefits.8

    • The growing wage bill could be reduced by 0.5 percent of GDP, including through streamlining public administration and government agencies. Plans to make compensation more performance-based should be advanced in order to improve public service delivery.9

uA01fig11

Medium-Term Fiscal Consolidation Scenarios

(in percent of GDP)

Citation: IMF Staff Country Reports 2018, 005; 10.5089/9781484337325.002.A001

Sources: Ministry of Finance; and IMF staff calculations.

13. Two other reforms are also necessary to ensure fiscal sustainability:

  • ➢ Reforms in the healthcare sector are critical to stop the perpetual accumulation of arrears. Legacy arrears are about 2 percent of GDP, and new arrears amount to an estimated 110 million kuna per month, half of which could be eliminated by removing exemptions and enforcing the collection of premiums for supplementary health insurance. Consideration should be also given to raising premiums and introducing co-payments for such supplementary benefits.10 In addition, the efficiency of the sector should be improved by reducing the large number of specialized centers and centralizing procurement. Consideration should also be given to moving the health insurance fund back under the Treasury to strengthen monitoring and control of expenditures.

  • ➢ The pension system needs to be put on a sustainable path.11 Essential reforms include: (i) tightening early retirement rules, (ii) accelerating the transition to the higher statutory retirement age, and (iii) expediting convergence of special regimes and privileged pensions with the general system.

14. Staff supported the authorities’ recent effort to strengthen fiscal governance and debt management. The Fiscal Responsibility Law, which is being finalized, includes the creation of a Fiscal Council with seven non-political members and its own staff. The Budget Act, also to be approved soon, will include an analysis of contingent liabilities as part of the budget process as well as a three-year spending limit, while ensuring appropriate flexibility. Staff welcomed measures to reduce debt vulnerabilities in the updated debt strategy, published in 2017, and especially encouraged further expansion of kuna-based borrowing to reduce FX exposure and develop the local bond market (Annex II).

Authorities’ Views

15. The authorities intend to continue to improve tax administration and are cont