Statement by Richard Doornbosch, Alternative Executive Director for the Republic of Croatia and Miroslav Josic, Advisor to Executive Director January 10, 2018

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

On behalf of the Croatian authorities, we would like to thank staff, lead by Mr. Sakr, for their productive engagement during the Article IV mission and express our appreciation for the constructive policy findings and recommendations reflected in their report. The authorities broadly agree with staff’s appraisal.

Recent Economic Developments and Outlook

Favorable economic developments continued in 2017, characterized by accelerated growth in economic activity and improved perception of the country’s degree of risk. Real GDP growth reached 3.3 percent y-o-y in the third quarter of 2017, mostly driven by a successful tourism season and further recovery in personal consumption and government spending. The consumer confidence index has remained above its long-term average, despite the crises in the Agrokor Group. The increase in employment and in the average nominal gross and net wage continued during the third quarter, although at a somewhat slower pace. All this contributed to a steady recovery of credit growth, which is projected to be 3.0 percent y-o-y in 2017 (based on transactions).

In the medium term, real GDP is projected to slow down slightly to 2.8 percent, mainly due to the expected lower increase in tourism revenues and slowdown in personal consumption growth. At the same time, investments are expected to pick up owing to stronger use of EU funds. The authorities share staff’s view that further implementation of structural reforms is needed to boost the potential growth. This should be addressed by the measures and activities defined in the new National Reform Programme (NRP) for 2018.

Fiscal Policy and Debt Management

The authorities are determined to use the positive growth momentum and to continue with the fiscal consolidation. In the last two years, strong fiscal adjustment brought the overall budget deficit to −0.9% of GDP in 2016 while the preliminary data for 2017 points to a surplus of 0.6% of GDP. As a result, public debt to GDP ratio shrank from 85.4% in 2015 and is projected to be around 78% by end-2017. Against this background Croatia exited from the Excessive Deficit Procedure (EDP) in June 2017.

The adopted State budget for the 2018–2020 period as well as the recent NRP envisages the continuation of prudent fiscal policy and an additional reduction in public finance imbalances. This encompasses measures on both the revenue and expenditure side as well as further improvement in tax administration and tax collection. The authorities share staff’s view that the level of public debt is still high and are determined to gradually decrease it to close or below 60% of GDP. This is also in line with the authorities’ commitment to start the official process of euro adoption.

Sustainability of public finance in the medium term will be based on four pillars, (1) strengthening the framework for public financial management and a further implementation of fiscal consolidation; (2) reduction of healthcare arrears and sustainability of the healthcare system; (3) improving the efficiency of the social benefits system; and (4) ensuring the long-term sustainability of the pension system. The new Public Debt Management Strategy for the 2017–2019 period adopted in January 2017 in combination with favorable market conditions, brought savings in interest rates payments of close to 0.3% of GDP.

As a wider measure to ensure public debt sustainability and improve the efficiency of state-owned enterprises (SOEs), the authorities have, under guidance of the World Bank, implemented financial and operational restructuring of the highway companies. However, the authorities share staff’s assessment that a further increase in productivity and efficiency of SOEs is needed. A new Fiscal Responsibility Act is planned to be adopted in 2018 after consultation with the EU Commission and the members of the Fiscal Policy Committee, aimed at further improving the budgetary framework. The introduction of real estate tax planned for January 2018, will be postponed as more time is needed to design an efficient and fair system.

Monetary Policy and Financial Stability

The monetary authorities will continue to pursue an accommodative monetary policy taking into account the anchor of exchange rate stability and risks to financial stability. The kuna liquidity of the banking system was further strengthened during the entire 2017 by foreign exchange interventions that alleviated appreciation pressures on the domestic currency. At the same time, the monetary authorities enabled easier access to the favorable kuna funding of banks allowing the formation of a pool of eligible assets to be used as a collateral in all central bank credit operations. The highly accommodative policy stance continued to improve financing conditions of all domestic sectors, thus supporting credit recovery. The monetary authorities will remain prudent in ensuring quality credit growth by continuing to encourage kuna-based lending and to consistently warn off the risks associated with lending in euros at variable interest rates.

The banking system remained well capitalized, profitable and liquid owing to improved economic fundamentals as well as sound prudential policies. The total capital ratio mildly increased to above 23% by end-June 2017. At the same time, banks on average remained profitable, although provisioning for possible losses associated with the Agrokor Group had a significant impact on their overall result. The latest stress tests showed strong resilience of the entire banking sector with respect to this crisis. Despite short term impediments, the ratio of NPLs to total loans continued to be on a downward trend and stood at 12.5%, the lowest level in six years.

The authorities have initiated a public discussion on the adoption of the euro. In this respect, they have published a Strategy for the Adoption of the Euro which should serve as a platform for public discussion on the costs and the benefits of joining the common currency union. The authorities remain committed to support the euro adoption and leverage on benefits this process could bring.

Competitiveness and Structural Reforms

The authorities acknowledge and put high on their agenda the need to implement a wide range of structural reforms aimed at improving the business environment, labor market conditions and the quality of public administration. The authorities have strong ownership over the NRP and have already implemented many reforms, which was also acknowledged by staff. Tax reform was introduced in 2017 aimed at reducing the total tax burden, developing a stable and predictable tax system as well as simplifying and reducing the tax administration. At the same time, the Action plan for administrative relief of the economy adopted in January 2017, resulted in 104 measures of which the implementation in 2017 allowed for administrative savings to the economy of up to HRK 1.5 billion or 30%.

The Draft Law on the Management of State Assets has been introduced at the end of 2017 which should start exploiting vacant state-owned real estate, particularly in tourism. Combined with measures aimed at removing impediments to the business environment, this should result in attracting FDI. The divestment process of state assets has continued and some or parts of the companies in the state portfolio have been sold to private investors, like the Port of Rijeka. Revision of the salary determination system in public administration and public services is envisaged for 2018, which should stimulate expertise and reward the performance of employees.

Lastly, the authorities agree with staff that the large-scale reform of social benefits has been postponed for now. The system of social benefits is envisaged to be coordinated and centralized by 2020 when a one-stop shop is planned to be introduced. However, the authorities’ view is that this part of reform should be performed to streamline the benefits to those in needs and to protect the safety net, but at the same time to address the demographic challenges to the country.