OREANDA-NEWS. A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Since late 2014, the Croatian economy has been gradually recovering from a six-year long recession, mostly on the back of strong exports, tourism activity, and consumer confidence. Medium-term growth is projected to remain moderate—about 2 percent annual real growth. Growth-friendly fiscal consolidation would help reduce vulnerabilities. Ambitious structural reforms are also needed to improve the efficiency of the public sector, the ease of doing business, and competitiveness. This would help increase income levels towards the EU average and reduce the very high unemployment. The announced national reform program is encouraging but will require decisive implementation of concrete measures in order to achieve its objectives.

Recent developments and outlook

1. The recovery has gained traction during 2015 and real growth registered 1.6 percent, notwithstanding a slowdown in the fourth quarter. EU accession and solid trading partner growth contributed to strong exports. Tourism has been growing and private consumption has begun to recover, thanks to improved confidence and disposable income due to the increase of income tax thresholds and low energy prices. IMF staff projects a further strengthening of growth to about 1.9 percent in 2016, aided by strong exports of goods and services and a continued pick-up in private consumption. Investment is also expected to increase as a result of the overall improved economic conditions and better absorption of EU structural and investment funds, while the deleveraging process is expected to steadily come to an end. Over the medium term, economic growth is therefore projected to stabilize at around 2–2? percent. Inflation is projected to return to positive territory in 2016 and to remain low over the medium term.

2. The external current account moved further into surplus in 2015, while external debt remains high. The current account registered a record surplus (5.2 percent of GDP), partly explained by a one-off cost of foreign-owned banks related to the Swiss franc loan conversion (about 2 percent of GDP). In the medium-term, export growth is projected to remain strong, but to decelerate as benefits from EU accession level off, and imports are projected to gradually increase, as consumption and investment continue to recover. As a result, the current account surplus will gradually decline and turn into a moderate deficit towards the end of the medium term. External debt declined to about 104 percent of GDP in 2015 and is expected to fall further over the medium term with the ongoing deleveraging and fiscal consolidation.

3. The balance of risks continues to be tilted to the downside. Persistently lower energy prices would continue to have a favorable impact on production costs and purchasing power, and accelerated reforms could further support growth and competitiveness, reduce vulnerabilities, and unleash the large unutilized potential of the economy. However, there are substantial downside risks, including a slowdown in external demand due to remaining uncertainties in the EU economic outlook, a normalization of global monetary conditions, which could lead to higher costs for the large public financing needs, and border disruptions associated with the refugee crisis. Furthermore, domestic political conditions remain challenging with possible adverse implications for reform implementation and the economic policy-making environment. To mitigate this risk it would be important to finalize and communicate the remaining details of the national reform program, adhere to the budget process outlined in Budget Law and Fiscal Responsibility Law, and preserve the independence of the central bank in line with the Statute of the European System of Central Banks.

Fiscal policy

4. The decline in the general government deficit in 2015 was stronger than expected. The overall deficit is estimated at 3.2 percent of GDP, compared to 5.5 percent in 2014. This was due to the cyclical upturn in revenues, some consolidation efforts, and a substantial decline in general government investment. On the revenue side, consolidation efforts included an increase in excises on fuel and tobacco, the full-year effect of the 2014 increase of health insurance contributions, and improved tax administration. On the expenditure side, efforts included measures to contain the wage bill (mainly seniority bonuses) and subsidies as some agricultural subsidies are now being paid directly by the EU Agricultural Guarantee Fund. Furthermore, preliminary data point to a one-off decline in public enterprise investment equivalent to about 0.8 percent of GDP, possibly due to lack of execution during the term of the care-taker government in the fourth quarter. As final financial statements become available, these estimated investments could be revised upwards, with possible implications for the size of the 2015 deficit, depending on the nature of financing of any increase in the reported investments.

5. The 2016 budget targets a deficit of 2.6 percent of GDP. This further decline of the deficit is based on a combination of a cyclical revenue upturn and a freeze of the overall “nationally-financed” expenditures, i.e., non-EU funded expenditures. There is a risk that there will be higher public investment this year, especially in view of last year’s reported decline in public enterprises’ investment. This risk could lead to a slightly higher deficit of 2.8 percent of GDP. The authorities emphasized that they will closely monitor and control all expenditure items, and will take compensatory measures as needed to ensure the achievement of the budget target. An acceleration of reform implementation, including in the health sector, which suffers from large arrears and inefficiencies, would ensure a faster reduction in the deficit and improve the quality of fiscal consolidation, which is currently focused on across-the-board expenditure freeze.

6. The national reform plan aims at a further steady ambitious fiscal consolidation over the medium term, which includes both tax and expenditure reductions. The authorities have expressed their determination to achieve the planned reforms. However, given the various downside risks, the mission is projecting a somewhat slower pace of expenditure and thus fiscal consolidation compared to the national plan. It would therefore be important to make sure that any reduction in taxes go hand in hand with other reforms that would create the fiscal space for such reductions. It would also be useful to finalize the remaining details of the planned reforms, with a view to enhance efficiency, growth, and equity. In particular:

  • The plan to streamline social benefits and reform the health sector in cooperation with the World Bank would help reduce the large cost of these benefits, while enhancing efficiency and equity. It would therefore be important to go ahead with, and build on the announced reforms in the health sector and to accelerate the implementation of the one-stop shop for the numerous other benefits to avoid duplication, while increasing means-testing to improve targeting.
  • The mission welcomes the containment of the large wage bill and the plan to make part of compensation performance-based in order to enhance incentives to improve efficiency and the quality of public service.
  • The mission also welcomes the plan to introduce a modern real estate tax that is appropriately phased-in, building on the existing communal fees system. The success of the introduction of the latter stages would require timely implementation of the necessary preparatory work such as modernizing the land registry and cadastre. Furthermore, it is important that any exemptions from the tax be very limited in order to facilitate the adoption of a low rate, while yielding substantial revenue.
  • The mission welcomes the intention to improve the absorption of the EU structural and investment funds, which would contribute to growth with relatively modest fiscal impact.
  • It would be desirable to strengthen public expenditure monitoring and control, and to put in place a contingency plan to guard against fiscal slippages should downside risks materialize.

Monetary policy and banking sector

7. At this juncture, there is no viable alternative to the quasi-peg to the euro, given the high degree of euroization. The mission encourages the authorities to continue to smooth sharp exchange rate fluctuations, while expediting structural reforms in order to enhance competitiveness. It would also be useful to take advantage of the strong balance of payments position to further bolster international reserves.

8. Staff encourages the CNB to continue to adopt an accommodative monetary policy stance within the limits set by the exchange rate anchor and financial stability objectives. Ample liquidity has been ensured, including through the recent introduction of a four-year structural reverse repo facility that has helped provide stable long-term kuna funding. The availability of such funding should help gradually reduce the high euroization and increase the traction of monetary policy.

9. The banking sector has remained robust despite the difficult economic conditions prevailing during the drawn-out recession. Continued conservative prudential policies and supervisory vigilance are needed to preserve this record. On average, the system is liquid and well-capitalized. Banks remained profitable in recent years with the exception of 2015 due to costs from the Swiss franc loan conversion. In staff's view such a linear bailout without any social criteria should had been avoided, as it increased the risk of moral hazard. The non-performing loan (NPL) ratio seems to have stabilized, but remains high (16.6 percent). Nonetheless, NPLs are fairly provisioned (56.6 percent). Recent anecdotal information suggests that some banks may begin to become more willing to lend with the improved outlook for both non-financial enterprises and households. In 2015, one small, but regionally important bank began the resolution process in accordance with the EU Bank Recovery and Resolution Directive.

Structural reforms

10. Ambitious structural reforms remain essential to enhance Croatia’s growth potential. Business environment indicators suggest significant room for improvement. The mission therefore encourages the authorities to reduce bureaucratic impediments to doing business, improve policy transparency and predictability, enhance the judiciary process, and strengthen anti-corruption efforts.

11. The high unemployment and low labor participation rates highlight the need for further reforms of the labor market and benefit systems. It would be important to make the regulations on temporary employment, severance payments and the hiring and retrenchment of employees less restrictive in order to encourage employment creation. Creating the fiscal space to reduce the high tax on labor would also help in this regard. A better targeting of unemployment and veterans benefits and implementation of the planned pension reforms, would help improve participation rates.

12. A determined effort to strengthen public sector management and advance the planned privatization in a transparent and fair fashion would help improve the efficiency of the economy and also put the large public debt on a faster downward path.

13. It is important that plans to streamline the large number and multiple layers of government bodies be ambitious in line with the initial announcements by the government. This would help reduce the large fiscal cost and substantial red tape, and improve regional equity and the quality of public service provision.