IMF: Republic of Croatia - Concluding statement of the 2014 Article IV consultation mission

03 March 2014

Economic conditions remain very difficult, with real GDP projected to contract for the 6th consecutive year in 2014. The banking system has remained stable, liquid and on average well-capitalised.

Economic conditions remain very difficult, with real GDP projected to contract for the 6th consecutive year in 2014. Fiscal policy has run out of space, while monetary policy is constrained by the need to prevent a contractionary revaluation of foreign currency indexed debts. To improve growth prospects, structural reforms are key that accelerate debt restructuring, enhance the capacity of the economy to adapt, and boost investment and labour market participation. At the same time, gradual fiscal consolidation is needed to preserve access of the economy to financing at acceptable conditions and to boost confidence in macroeconomic management. The banking system has remained stable, liquid and on average well-capitalised. [Following sections abridged.]

Recent Developments, Outlook and Risks

• Croatia remains stuck in an unusually drawn out recession.
• External financing conditions have remained manageable thus far, but Croatia’s country risk premium has increased relative to peers. 
• Growth prospects remain subdued in the short term, but a gradual recovery is expected from 2015.

Reviving Growth

• With many of Croatia’s economic problems owing to the persistent economic contraction, reviving economic growth and generating employment is a high priority. To this end, both weak domestic demand and long-standing structural impediments to growth need to be addressed.
• High private sector debt remains a key obstacle to the recovery. 
• The authorities have made commendable progress in enhancing the efficiency and growth capacity of Croatia’s economy.

Advancing Sustainable Fiscal Consolidation

• After a good attempt at consolidation in 2012, in the deficit (cash basis) widened again in 2013 to around 5½ per cent of GDP, reflecting weak revenues, the assumption of debts and arrears from public hospitals and state-owned enterprises, and fiscal costs related to EU accession.
• While very difficult to implement in an environment of economic contraction, sustained and predictable fiscal consolidation is critical to strengthen confidence in macro-economic management, boost sentiment, and retain the economy’s access to financing at acceptable conditions.
• Staff’s assessment of fiscal policy in 2014 is based on the broad parameters of a planned budget revision that the authorities shared with IMF staff. The revised budget still needs to be approved by the cabinet and the assembly… Taken together, staff estimates net structural adjustment contained in the revised budget at 0.8-1.1 per cent of GDP (annual impact), resulting in a projected 2014 cash deficit of 4-4½ per cent of GDP.
• Provided these plans are implemented as foreseen and without delay, and the quantification of the measures’ budgetary impact is realistic—which IMF staff could not verify in all cases—the revised budget constitutes a substantive first step toward budgetary consolidation.
• Restoring financial balance in the health sector is an urgent priority.
• State-owned enterprises (SOEs) are a persistent source of contingent liabilities to the government. 

Maintaining Monetary and Financial Stability

• Monetary policy has continued to use the kuna-euro exchange rate as anchor, reflecting the high degree of euroisation in the banking system. 
• While the set of monetary policy instruments is appropriate at this juncture, the central bank should stand ready to adapt its toolkit as needed. In particular, in case financial or inflationary pressures were to reemerge at some stage, fine-tuning of liquidity could be conducted more flexibly and accurately through open market operations than regulatory instruments.
• Notwithstanding the protracted recession, Croatia’s banking system has remained stable, liquid and well-capitalised, even though financial strength varies across banks. The banking system’s aggregate capital adequacy ratio is, at almost 21 per cent, the highest in the region. Reported profitability has fallen, reflecting inter alia commendable changes to loan classification rules that bring loan-loss provisioning closer in line with peers. Some caution appears warranted regarding the recent increase in bank loans to state-owned enterprises, lest to under appreciate risks to both banks and the government.

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