Public Information Notice No. 02/86

Public Information Notice: IMF Concludes Article IV Consultation with the Republic of Croatia

August 8, 2002

On August 5, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Croatia.¹

Background

Croatia experienced solid growth in the last two years, with growth rates of around 4 percent, exceeding those of the euro area and of many other transition countries. The recovery, initially propelled by private consumption and exports, has more recently extended to investment, encouraged by easy access to credit and public infrastructure spending. After decelerating at the end of 2001 in the wake of the slowdown in Europe, growth resumed strongly in the first quarter of 2002 supported by domestic demand. While private consumption is likely to slow down after a rapid increase in household indebtedness, leading indicators confirm that the prospects for the tourist season are good while exports are likely to benefit from the expected recovery in Europe. In spite of sizable employment creation by small and medium-sized enterprises, unemployment remains at about 16 percent of the labor force, which is in line with other transition countries.

Inflation is low despite continuing upward adjustment of administered prices. Exchange rate stability, trade liberalization, wage moderation, productivity increases, and enhanced competition in retail trade, all contributed to ease inflationary pressures. Annual retail price inflation, after reaching 7.4 percent at the end of 2000, fell to 1.8 percent in May 2002. Indicators of core inflation and producer price inflation confirm that underlying inflationary pressures remain muted. However, inflation in sectors less exposed to competition, like services, remains substantially higher.

The external position is strong. After rising to 3.1 percent in 2001, the current account deficit is expected to decline to 2.8 percent in 2002, with strong tourism inflows and income transfers offsetting large imports of capital goods. Capital inflows related to euro conversion, privatization receipts and government borrowing have continued to strengthen international reserves and external vulnerability indicators have improved.

The fiscal position remains weak. Aided by reforms in public administration and social transfers, the fiscal deficit of the central government was reduced from 7.4 percent of GDP in 1999 to 5.4 percent in 2001. Nonetheless, expenditure outside the central budget increased substantially as a result of an ambitious highway construction program, and the general government deficit is expected to remain unchanged at 6.6 percent of GDP in 2002.

Under pressure from capital inflows, the exchange rate has slightly appreciated. The Croatian National Bank (CNB) intervened repeatedly to stem these pressures, further boosting international reserves. Encouraged by the favorable inflation outlook, the CNB only partially sterilized these inflows, trying to avoid the emergence of interest rate differentials that would attract further capital. The abundant liquidity has reduced interest rates to very low levels and credit to both consumers and businesses has grown briskly.

Despite a run on the third largest bank, the banking system has remained stable. The prompt reaction of the authorities, with the provision of liquidity support and the rapid reprivatization of the bank, helped contain the crisis. While important reforms in the financial sector have contributed to its further strengthening and vulnerability indicators have improved, the indirect exposure of the banking system to exchange rate risk remains a significant concern.

Progress in structural reforms has continued to be slow. Some progress has been made in pensions, public sector wages, social transfers, and fiscal administration. However, reforms have lagged behind in privatization, health, judiciary, education, labor market, and subsidies. These delays have postponed efficiency gains and undermined the economy's medium-term growth prospects.

Integration in the international trading system is all but complete. The trade regime has been liberalized, and Croatia has become a member of the WTO and has concluded free trade agreements, including a Stabilization and Association Agreement with the EU, covering 28 countries.

The outlook for 2002 is moderately positive. With a good tourist season and improving external conditions, GDP growth is likely to reach 3.5 percent in 2002. The risks appear evenly balanced. Even though the recovery in Europe may turn out to be slower than expected, there is a sizable prospect that private consumption will continue to be strong.

Executive Board Assessment

Executive Directors commended Croatia's recent strong economic performance, noting that growth has been restored to above the central and east European average, while inflation had been reduced to EU levels. The external position has strengthened considerably, with a low current account deficit, a high level of international reserves, and ready access to international capital markets. Croatia has also made good progress in trade liberalization and integration with the EU and other regional markets. However, Directors expressed concern about the still high fiscal deficit, the rising public debt ratio, and delays in the area of structural policies. They therefore urged the authorities to accelerate fiscal consolidation and structural reforms in order to stabilize the debt ratio and to boost employment and economic growth.

Directors agreed that, given Croatia's high tax burden and expenditure ratio, fiscal consolidation should rely primarily on expenditure reforms—which are also needed to make room for EU and NATO-related spending, as well as education and infrastructure programs. Directors stressed several priorities for expenditure reductions: the wage bill, mainly through employment cuts in defense, and through administrative reforms; subsidies—where Directors questioned the newly-decided increases for agriculture, shipbuilding and other sectors; and transfers, through further reform of the first pension pillar, the cessation of temporary special pension payments, and continuing health sector reform. The social impact of these measures should be mitigated by an appropriately funded social safety net and well designed active labor market policies.

Directors urged the authorities to improve fiscal transparency. They attached particular importance to the compilation of reliable and timely general government data, and the inclusion of the new funds for employment and growth and for regional development in the 2003 budget. Off-budget funds should be included transparently in the general government.

Directors supported the monetary framework, with its emphasis on broad exchange rate stability in the pursuit of low inflation. The favorable external current account position and competitiveness considerations suggest that the level of the exchange rate is broadly appropriate. Nevertheless, competitiveness should be further enhanced by removing remaining barriers to foreign trade, and by structural policies and wage moderation. In light of the high degree of euroization, and the weak and uncertain monetary policy transmission mechanism, Directors found the focus on the exchange rate by the CNB appropriate at this stage. While a few Directors considered such a policy suitable for Croatia going forward, most Directors suggested that the CNB gradually increase its focus on inflation, and accept the greater exchange rate flexibility that would likely result. Such a refocusing should be accompanied by measures to further develop financial markets and promote the public understanding of monetary policy.

Directors noted the rapid growth of the monetary aggregates due to euro conversion and unsterilized capital inflows, which occurred in a setting of growing confidence in the currency and the banking system. While inflation pressures are muted at present, and broad money growth has recently slowed, Directors urged the CNB to react promptly should signs of inflation emerge. They considered that the CNB should tighten its monetary stance—through increased sterilization, if needed—if excess liquidity and low interest rates rekindle inflationary pressures, especially if fiscal consolidation were to provide insufficient support.

Directors noted with satisfaction the substantial strengthening of the financial system. Nonetheless, they observed that some vulnerabilities remain, especially from credit risk due to unhedged currency exposure. In their view, this exposure may be encouraged by public perceptions that exchange rate risk is absent—a concern that also supports the call for greater exchange rate flexibility. While promoting the development of the financial markets, the authorities should also cautiously liberalize capital movements to allow the development of markets for hedging instruments. In view of the rapid growth of bank credit, Directors recommended that the CNB direct increased supervisory attention to the soundness of banks' lending decisions and insist on appropriate provisioning. Directors agreed that while creating a single supervisory agency is premature at present, there is scope for more effective coordination among the regulatory bodies and possibly the unification of nonbank supervisory functions under one umbrella. Directors welcomed the strengthened legal and regulatory framework for combating money laundering and the financing of terrorism.

Directors urged the authorities to give a fresh impulse to structural reform, focusing on measures to improve efficiency and promote a business-friendly environment. The still large role in production of the government—including local authorities—should be reduced by privatization and elimination of subsidies. Public administration should be made more efficient by delegating responsibility and initiative to institutionally strengthened local governments. Directors also viewed greater flexibility of the labor market as necessary to reduce unemployment, which is high relative to EU levels.

Directors encouraged the authorities to improve national accounts, price, and labor statistics; shorten the lags in the publication of data; reduce the discrepancies between quarterly and annual national accounts data; and strengthen the reliability of unemployment statistics, in particular in the official unemployment register.