On May 14, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultation1 with the Republic of Croatia.
Croatia remains stuck in an unusually drawn out recession. In 2013, real GDP contracted for the 5th consecutive year, and stands now at less than 90 percent of the end-2008 level. Unemployment has risen to 17 percent. Domestic demand remains depressed as corporations and households focus on reducing excessive debts accumulated in the 2000s. Exports and Foreign Direct Investment (FDI) are also feeble, reflecting deep-seated structural weaknesses and poor trading partner growth. Macro-policies that could revive growth rapidly are beyond reach: fiscal policy has run out of space, while monetary policy is constrained by the need to keep the kuna-euro exchange rate stable, lest a depreciation cause a revaluation of euro-indexed debts.
The recession is putting pressure on the public finances. In 2013 the deficit (cash basis) widened to around 5½ percent of GDP, owing to weak revenues and the assumption of debts and arrears from state-owned enterprises. Public debt now exceeds 60 percent of GDP and is increasing rapidly. Reflecting these developments, all major rating agencies have downgraded Croatia to sub-investment grade. From this year, fiscal policy is subject to the European Union’s Excessive Deficit Procedure.
The government has started tackling long-standing structural issues, such as restructuring and/or privatization of state-owned enterprises, passage of laws that facilitate investments, the introduction of an out-of-court settlement procedure for insolvent corporations, the reduction of work force restructuring costs, and the easing of hiring restrictions.
The outlook is for another contraction in 2014 of almost 1 percent. Real domestic demand would remain feeble, reflecting both weak private sector demand and fiscal consolidation, while exports would benefit somewhat from the projected pick up in the euro area. Inflation would remain low. In 2015 a tepid recovery would set in, as the impact of private sector deleveraging would begin to recede and external demand strengthens further. Long-term potential growth is projected at around 2 percent.
With traditional fiscal and monetary policy responses out of reach, private sector debt restructuring and measures to attract FDI provide the best prospect to revive growth in the short- to medium term. Credible and sustained fiscal consolidation is needed to strengthen confidence in macro-economic management. Given the protracted economic weakness, it is adequate to stretch fiscal adjustment and start with steps least harmful to demand. The central bank has maintained confidence in exchange rate stability through a limited but effective set of instruments, but should continue accumulating foreign exchange reserves until coverage is fully in line with standard adequacy metrics.
Executive Directors noted that the Croatian economy remains in recession, unemployment is widespread, the fiscal position has worsened, and downside risks weigh on the near-term outlook. With countercyclical responses limited by the exchange rate regime and lack of fiscal space, Directors encouraged the authorities to rebuild fiscal buffers and to undertake deeper institutional and structural reforms to revive growth and reduce vulnerabilities, including by accelerating private sector debt restructuring.
Directors agreed that sustained fiscal consolidation is needed to secure debt sustainability. Noting the front-loaded adjustment in the context of the European Commission’s Excessive Deficit Procedure, they stressed that fiscal policy for the period ahead needs to manage a difficult tradeoff between the speed of consolidation and its drag on economic activity. More broadly, Directors advised the authorities to develop comprehensive plans to frame fiscal adjustment over the medium term, in order to reduce policy uncertainty and maximize the impact of consolidation on confidence. Such a plan should give consideration to both revenues and expenditures measures, including a modern property tax and an overhaul of the public finances at lower levels of government.
Directors generally supported the authorities’ plans to use monetary policy to safeguard their exchange rate objectives and to maintain adequate reserves. They also took note of the staff’s assessment that the real effective exchange rate may be modestly overvalued but underscored the uncertainty surrounding such assessment.
Directors commended the central bank for its bank capitalization policy, which has bolstered the stability of the financial system by ensuring that banks possess ample loss-absorbing capacity. Nonetheless, Directors encouraged the authorities to remain vigilant against risks to both banks and the sovereign from loans to state-owned enterprises.
Directors welcomed the progress made in structural reforms but highlighted that further efforts are necessary to enhance external competitiveness and facilitate balance-sheet repair in the private sector. They underscored the need for reforms to raise labor force participation, address labor market rigidities, restructure state-owned enterprises, and improve the business and investment climate, particularly through judicial reform. The labor legislation currently under parliamentary consideration could strengthen the labor market’s capacity to adapt to shocks. Continued efforts should also be made to ensure the rapid and efficient absorption of EU funds.