Introduction

The authorities welcome the thorough staff analysis and mostly agree with the staff’s recommendations. This is the first Article IV consultation to take place following the successful conclusion of the Stand-By Arrangement last November, and it provides a good opportunity to focus on economic issues from a longer-term and analytical perspective rather than from a program perspective. The authorities value their close cooperation with the Fund, and consider that the consultation process has worked well and has focused on topics of importance to the Croatian economy.

The authorities strongly emphasize maintaining the good macroeconomic performance of recent years and further invigorating structural reform. The prospect of EU accession continues to act as an important anchor, providing one impetus for further progress in these areas. The negotiations with the EU have been gaining momentum after the process of screening of Croatian legislation by the European Commission was finalized. A key objective is to keep macroeconomic stability and to maintain progress on per-capita incomes and hence promote convergence with the EU, by continuing to attract FDI and developing key growth sectors while restructuring lagging ones.

Economic performance and outlook

From a longer-term perspective, the Croatian economy continued to exhibit solid growth, averaging 4 ¾ percent over the past five years, propelled by private consumption and investment. Unemployment has continued to decline to levels not seen for many years, while inflation has remained well contained despite rising energy and commodity costs. Savings have been healthy, aided by improving government savings, which helped maintain a rising investment share in the economy. FDI has correspondingly also been strong.

The current account deficit has widened although, as the staff points out, competitiveness was adequate and wage growth moderate. Goods exports have grown, gaining rather than losing market share relative to that of a few years ago. Tourism has also been strong, with Croatia viewed as an attractive destination possessing great natural beauty. Imports have, however, also been rising, partly driven by higher energy prices and partly by rapid credit growth in response to the availability of cheap foreign loans.

Looking forward, prospects for growth remain good, with perhaps a temporary acceleration in domestic demand as the spending effect of the settlement of the “pensioners debt” works itself through. Over the medium term, potential growth is likely to continue to improve somewhat, reaching perhaps 5 percent, given continuing strong investment, but also assuming that restructuring takes place and that reform results in an improving business environment. Following EU accession, FDI could rise and the convergence process could accelerate even further, allowing for an additional pickup in potential growth.

Monetary policy and external vulnerability

The Croatian National Bank (CNB) continued to achieve low inflation, maintaining its strong track record in this regard during 2006. Core inflation declined from 3.0 percent in December, 2005 to 2.3 percent in December, 2006, while headline inflation, aided by declining oil and food prices, fell more strongly—dropping to 2.0 percent from 3.6 percent over the same period. The CNB kept its focus on mitigating vulnerabilities by maintaining exchange rate stability while standing ready to take steps to address the risks associated with bank foreign borrowing and rapid credit growth. This readiness was already expressed to the Board on a number of occasions, including in our Buff statement of March 23, 2006 and in the Annex to the government’s Letter of Intent for the 3^rd Review of the Stand-By Arrangement in October, 2006.

It should be said at the outset that external vulnerability remains manageable, with higher external debt on the one hand counterbalanced by higher gross official reserves, strong market access, and a healthy financial sector (which is in any event 90 percent foreign owned) on the other. However, the CNB remained concerned with the possible macroeconomic implications of persistently high and increasing credit growth and a rising current account deficit in an environment of already high—in relation to neighbors—external debt-to-GDP and credit ratios. Another consideration was that fiscal policy for 2007 is already set from the legislative point of view. Finally, the CNB observed that the set of measures (that is, all such measures falling within the CNB’s competence, well-described in paragraph 21 of the Staff Report) taken in an attempt to arrest high credit growth and already implemented during 2006 were not sufficient enough to achieve the expected result.

Indeed, credit growth accelerated in the last month of 2006, reaching 22.9 percent in December 2006 (y/y), driven by increased foreign borrowing by commercial banks. During just the last quarter of 2006, banks increased their external debt by almost 11 percent (an additional €1.3 bn), with the bulk of it used to fuel new credits; according to CNB estimates, banks needed only some €150 million of additional borrowing to comply with the broadening of the foreign-exchange liquidity requirement mandated to occur by year-end. This in turn caused the total external debt-to-GDP ratio to increase to 86.1 percent at end-2006 from 82.5 percent at end-2005, and the current account deficit to deteriorate further to 8.1 percent of GDP in 2006.

In view of the above considerations, CNB responded with enacting a temporary credit control measure in December, 2006, described in the Staff Statement. The prudential measures already taken, while possibly still having a lagged effect, and while no doubt helping to maintain the quality of new credits, do not necessarily curb credit growth. Further, the CNB has no doubt that an important step to improving the external balance is to slow down credit growth. That being said, the CNB is fully aware of the partial effectiveness of the credit control measure, i.e., that it cannot entirely solve the underlying problem of increasing external imbalances, but it considers that the measure adds to the overall efforts, and that it serves as an important signaling function.

Fiscal policy

The authorities have implemented a successful policy of fiscal consolidation over the past few years, in agreement also with staff in the context of the successfully completed Stand-By Arrangement. The overall general government deficit has declined from 6.2 percent of GDP in 2003, to roughly 3 percent by 2006 as estimated on a preliminary basis. Even during 2006, a better-than-expected revenue performance was mostly absorbed into a better-than-programmed fiscal balance, with the expenditure side continuing to experience contraction as a ratio to GDP. A supplementary budget was implemented to help achieve this result. A series of measures contributed to this outturn, including pension reform, wage moderation, and investment cuts. The changes in the pension formula (already enacted), should continue to produce fiscal benefits through the medium term. The staff’s calculations indicate only a moderate role for automatic stabilizers. In the context also of the Stand-By Arrangement, the deficits of the Development Bank were scaled down.

The authorities plan further medium-term fiscal consolidation, taking account of the impact of necessary structural reforms, projected growth, development requirements as expressed in the Strategic Development Framework, and Croatia’s aspirations for EU accession and eventual ERM-2 entry.

The planned improvements do consider that there will be continuing success in structural reforms. These include not only the pension reform already mentioned, but also a plan to continue reducing subsidies gradually, and significant reforms in the health sector (these were described in more detail in our last Buff statement as they formed an important part of the Stand-By Arrangement). Finally, the staff’s debt-sustainability analysis shows contained and further declining levels of the public debt-to-GDP ratio, while the bound tests generally show that the public debt ratio is robust to a number of possible shocks.

Structural reform and the financial sector

A number of reforms were already mentioned when considering the government’s medium-term fiscal plan. Other notable areas include plans for shipbuilding, steel, and railways restructuring, as well as privatization. On privatization, the government is considering a plan to cancel part of the debt of 200 enterprises on a case-by-case basis and only in the context of their privatization to improve their balance sheets and make them more attractive privatization candidates. It will also exempt potential investors from a requirement to buy all outstanding shares. A block of 15 percent of shares in the national oil company (INA) has already been sold to private investors (both foreign and domestic). The sale was very successful, and the share price (the company was jointly listed with the London Stock Exchange) has shown a strong tendency to rise. A tender for an advisor to the sale of 49 percent of the telecom company has already been launched. Additional ideas and a possible amendment to the Privatization Act are also being considered, all with a view to strengthening privatization (i.e., shortening the time needed for the privatization process, and making the procedures less complicated and more efficient).

On the financial sector, the independent non-bank supervisor (HANFA) has been operating now for about one year. It has done a number of audits of transactions involving brokerages. The leasing law was approved by parliament in December, 2006, which is a welcome development. Finally, the authorities expect an updated FSAP exercise to be conducted in a coordinated manner with the European Commission’s “Peer Review” exercise later in the year.