Country Report Croatia
Croatia will join the European Union on 1 July 2013, but its accession is unlikely to bring about a short-term relief from its economic problems, as structural issues like weak competitiveness and a poor business climate remain unaddressed. Following three years of recession (stagnation in 2011), Croatia's economy contracted by 2% last year. High unemployment and fiscal austerity measures depress domestic demand while external demand remains weak. Growth this year is expected to remain negative at about -0.5%. Amid rising concerns about public debt sustainability, Croatia's government remains committed to its fiscal consolidation strategy. However, its over-optimistic growth assumptions will likely force it to take additional measures later this year. While faltering domestic demand helped balance the current account last year, foreign debt service and thereby exposure to exchange rate volatility remains a significant external risk due to Croatia's high level of foreign debt (113% of GDP). Still, ample foreign exchange reserves should continue to support the central bank's ability to stabilize the exchange rate and thereby mitigate this risk.
Economic structure and growth
Croatia is a small central European economy with a nominal GDP of USD 58bn (2012). Once approved by four remaining national parliaments, it will become the 28th member state of the European Union on July 1st, 2013. Compared to the EU average, as well as regional peers, Croatia is still relatively poor, as nominal GDP per capita at PPP amounts to USD 17,904. In spite of relatively solid pre-crisis growth, this amounts to a mere 40% of Austrians' annual income.
Croatia's economy is dominated by the tourism sector, which is mainly concentrated along the Adriatic coastline. It attracts about 3m tourists each year, mainly from Austria, the Czech Republic, Germany and Italy. Tourism activity is highly seasonal and focused on the summer months. It provides employment opportunities not only for Croatians, but also for people from other former Yugoslav republics. Besides tourism, Croatia features an industrial sector that contributes about 25% to GDP and focuses on the production of machinery, foodstuffs and ships. The latter, still mainly state-controlled, has been in decline for several years, however. Both in terms of exports and imports, Italy is Croatia's main trading partner, followed by Germany, Bosnia & Herzegovina, and Austria. Similar to other economies in the Mediterranean, Croatia currently suffers from relatively weak competitiveness and a poor business climate, which prevents the country from fully exploiting its growth potential and catching up with wealthier EU peers in the region. Moreover, state-ownership is still widespread. In this regard, we note that EU accession is unlikely to change this trend, unless Croatia embarks on comprehensive structural reforms.
Croatia's banking sector has so far proved its resilience amid a protracted recession and remains well-capitalized overall. Even though the sector-wide non-performing loan (NPL) ratio increased from 7.8% in 2009 to 13.3% of total loans in June 2012, more prudent lending activity led to a further improvement of the sector's capital adequacy ratio of 20.2%. Given an NPL-ratio of about 25%, asset quality of corporate loans is particularly poor, while household loan quality saw a far smaller deterioration. Given Croatia's poor economic outlook, very high unemployment and ongoing deleveraging by foreign parent banks reducing the possibilities to roll-over debt, asset quality is likely to deteriorate further this year. However, according to recent stress tests conducted by the Croatian central bank, the sector's favorable capitalization levels should ensure its stability even under rather adverse scenarios. Notwithstanding, we note that the sector's performance remains heavily exposed to exchange rate movements, as 56% of loans are kuna-denominated foreign-currency indexed loans, while about 20% of loans are predominantly euro-denominated foreign currency loans. So far, however, ample foreign exchange reserves enabled the Croatian central bank to stabilize the kuna-euro exchange rate. Going forward, given the stable performance of the foreign-currency generating tourism sector, as well as a possibly more favorable risk perception following Croatia's expected EU accession, the risk of a major weakening of the local currency should be limited.
Following a very deep recession in 2009, when GDP fell by a staggering 7%, Croatia's economic growth did not reach positive territory for a period of three years. However, this year's expected GDP contraction of 0.4% comes in smaller than last year's (-2%), as net external demand and (government-induced) gross fixed investments are expected to show some limited growth. Still, domestic demand will remain depressed by very high and rising unemployment levels, private sector debt reduction, as well as urgently needed fiscal austerity measures. Meanwhile, external demand could turn out to be weaker-than-expected, particularly so if the euro area sovereign debt crisis were to worsen, which could also lead to rising debt refinancing costs for Croatia's heavily-indebted economy.
 Foreign-currency indexed loans are loans in kuna whose interest rates are indexed to a foreign currency. [back to text]
Political and social situation
Since December 2011, Croatia is governed by a coalition cabinet under the leadership of Prime Minister Zoran Milanović of the Social Democrat Party (SDP). Besides Milanović's party, the coalition comprises the Croatian People's Party (HNS), the Istrian Democratic Assembly (IDS) and the Croatian Pensioners' Party (HSU). The government currently holds 80 out of 151 seats in the Croatian parliament and has been fairly stable so far. The next parliamentary elections will not be due before December 2015, which should provide the current cabinet with sufficient time to implement urgently needed structural reforms.
As widespread corruption and problems related to a weak legal system and organized crime had been singled out by the European Commission as important issues that needed to be tackled before Croatia's EU accession, considerable efforts, particularly in the field of corruption control, have been deployed in recent years. While increased attention for Croatia's corruption issues led to various convictions, including a former prime minister, it also revealed the considerable size of the problem. Unsurprisingly, the EU remains concerned about this issue, even as it refrained from ongoing post-accession monitoring that had been implemented in the cases of Bulgaria and Romania, which face similar problems. Notwithstanding, we note that the problem is unlikely to be completely solved in the short-term.
The current social situation is characterized by very high and rising unemployment levels, particularly among young people, as labor market rigidities and a difficult economic situation depress hiring. Compared to early 2007, Croatia's unemployment rate doubled to almost 20% last year, while youth unemployment doubled from 25% to about 50%. Croatia's tense social situation could result in rising anti-austerity sentiment while the government is forced to intensify its efforts to rein in recurrent large budget deficits. In recent months, the number of anti-austerity demonstrations had been on the rise and could affect government policy going forward. Moreover, the government's weak performance during Croatia's first elections for the European Parliament suggests rising disenchantment with current policies.
Croatia's external relations mainly center on its accession to the EU and the strengthening of its ties with other former Yugoslav republics. In this regard, the recent resolution of a decades-old banking row with neighboring Slovenia proved particularly important to the country, as Slovenia might have blocked Croatia's EU entry. Even though ongoing war crimes trials tend to reignite nationalist sentiment, bilateral relations with Bosnia-Herzegovina, Montenegro and Serbia have improved markedly, while Croatia promised to assist these countries on their path to EU membership.
Since taking office in December 2011, the economic and fiscal policies of the current Croatian government have been dominated by the need for fiscal consolidation, as the country's recession drags on and public debt levels increased, triggering concerns about public debt sustainability. So far, the government's austerity efforts focused on the rationalization of the public sector, the reduction of public sector benefits, cuts to non-discretionary welfare spending, and faster privatization of state property, including the loss-making Brodosplit shipyards in response to EU demands. The cabinet adopted long-overdue structural reforms of the pension system and the labor market in order to decrease currently very high unemployment rates. Moreover, a new law on strategic investments should reduce investment barriers.
Progress on fiscal consolidation has remained lackluster, so far. Even though Croatia's cabinet met its 2012 budget deficit target of 4% of GDP, this could only be achieved through lower-than-budgeted capital expenditures, as the government faced cost overruns in the public sector wage bill, as well as pension and health care spending. While this decision hurt economic growth, it also reflected ongoing problems in restraining non-discretionary social spending, which constitutes the bulk of Croatia's sizeable fiscal spending. We note that this lingering problem keeps public expenditure high (about 40% of GDP) and forces to the country to maintain one of the highest tax rates on the Balkan. Moreover, the heavy tax burden reduces incentives for people working in the informal sector (about 20% of the population) to join the formal economy.
This year's budget deficit target has once more been set at 4% of GDP, but we caution that it is based on an, in our view, highly overoptimistic growth estimate of 1.8% (vs. general expectations of continued recession). Even worse, owing to the above-mentioned cost control shortcomings, recurrent cost overruns are highly likely. Provided the budget target can be met once more, Croatia's public debt ratio (including publicly guaranteed debt) is expected to increase from 68% of GDP in 2012 to 70% this year. Owing to the likely upward deviation from the budget target, we stress that public debt may increase faster than expected, which could lead to renewed concerns about debt sustainability. These concerns could translate into declining access to international capital markets, as Croatia needs to refinance about USD 3bn of maturing public debt following several recent sovereign debt downgrades to junk status by major rating agencies. In spite of these issues, Croatia's government denied being interested in an IMF credit line. While ample liquidity on international capital markets and the search for yield should help the country refinance its debt, we do not exclude the possibility that market access might suffer from spillover effects in case neighboring Slovenia were to receive an EU/IMF bailout package.
Croatia's monetary policy mainly focuses on the stabilization of the EUR/kuna exchange rate, given the sensitivity of the country's sizeable private and public debt stock to exchange rate volatility. Benefitting from its ample level of foreign exchange reserves (about 25% of GDP), the central bank has sufficient firepower to intervene in foreign exchange markets, if needed, which it did successfully last year. Similar to previous years, the central bank tried to stimulate credit growth by means of a 0.5 percentage point reduction of the reserve requirement ratio to 13.5%, but owing to weak credit demand we doubt that this change will have a marked impact on credit uptake. Reflecting the temporary effect of a VAT-hike and a rise in regulated energy prices, consumer price inflation increased from 2.3% in 2011 to 3.4% last year, but weak demand-side pressures should limit headline inflation to about 3% this year.
Balance of Payments & external position
Following several pre-crisis years of sizeable current account deficits, the recession-driven contraction of domestic demand brought with it the almost-balancing of Croatia's current account in recent years. A gradual increase of the tourism-driven structural services surplus from 13% of GDP in 2009 to about 16% last year also contributed to the improvement. Given a combination of relatively stable demand for tourism-related services and continued weakness of domestic demand, the current account is expected to remain in balance in the coming years. As net foreign direct investment inflows and net portfolio inflows (net of foreign currency bonds) amounted to about 1.5% and 2.8% of GDP, respectively, last year, Croatia's foreign exchange reserves increased from USD 14.4bn in 2011 to USD 14.8bn last year. Going forward, we expect ongoing foreign exchange reserve accumulation, which should ensure the central bank's ability to stabilize the euro-kuna exchange rate and thereby mitigate risks evolving from Croatia's sizeable foreign debt and foreign currency exposure.
Owing to Croatia's large foreign debt exposure, which increased to about 110% of GDP last year, Croatia's external position is relatively weak. Notwithstanding, we believe that associated risks remain manageable, given the central bank's ability to limit exchange rate volatility and the fact that most of the debt load has medium- to long-term maturities. About 20% of external debt is owed by Croatian enterprises and another 10% represents bank lending, part of which constitutes relatively stable interbank funding provided by Western European banks to Croatian subsidiaries. Short-term debt amounts to a limited 15% of total external debt. Moreover, foreign exchange reserves are expected to cover about 75-80% of debt service costs.