Country Report Croatia
Croatia’s economy is heading for its sixth year of recession, as ongoing deleveraging efforts and structural weaknesses depress growth. Amid worrying public debt dynamics, Croatia’s government increased its fiscal consolidation efforts and adopted some structural reforms.
Strengths (+) and weaknesses (-)
(+) Favourable geographic location
Thanks to its location on the north-eastern shore of the Adriatic Sea, Croatia benefits from close proximity and favourable transportation routes to major industrial centres in Austria, Germany and Italy. A pristine coastline and well-preserved historic cities support the country’s tourism potential.
(-) Narrow economic base
Reflecting the dominant position of the Croatian tourism sector, the diversification of the Croatian economy in terms of sectors and export destinations is low, exposing it to external shocks and limiting its overall growth potential.
(-) Poor business climate and weak competitiveness
Croatia has so far failed to implement urgently needed structural reforms that could boost its competitiveness and growth potential. An obstructive bureaucracy, cumbersome legislation, and persistent corruption problems further undermine the country’s business climate.
(-) Elevated foreign-currency denominated public and private debt levels
In spite of ongoing deleveraging efforts by companies and households, largely foreign currency denominated debt levels remain elevated, depressing domestic demand and exposing the private sector to a depreciation of the kuna. Public debt dynamics remain worrisome, as the government fails to rein in budget deficits.
1. Another year in recession, before EU funds may support growth in 2015
Croatia’s economy remained in recession for the fifth year in a row in 2013, as economic output contracted by 1% last year, contributing to a cumulative real output loss since 2009 of 12%. While private consumption and investments remained depressed by ongoing deleveraging efforts and very high and rising unemployment, export growth turned negative, as external demand from main trading partners (Bosnia and Herzegovina, Italy, Slovenia) remains very weak and the restructuring of the shipbuilding sector depressed industrial production. Due to the Croatian government’s postponement of urgently needed fiscal consolidation measures amid concerns about a further weakening of domestic demand, public consumption constituted the only positive growth impetus last year. Since Croatia’s government has to finally embark on meaningful fiscal consolidation this year amid rising pressure from the European Commission and financial markets, public consumption growth will also turn negative this year. As households and corporates continue to reduce their debt overhang, domestic demand growth is expected to turn negative across the board, leaving net exports as the sole growth driver. Yet, its contribution to growth remains limited by weak external demand and an overvalued exchange rate, which the central bank has to defend given large positions of euro-denominated debt. Consequently, Croatia’s economy is expected to contract by 0.6% this year before EU funds may support growth next year, pending the country’s ability to provide the necessary co-funding for EU investment projects.
2. First steps towards fiscal consolidation and reforms amid worrying public debt dynamics
Croatia’s government finally embarked on urgently needed fiscal consolidation and structural reforms in recent months, as the country entered the European Commission’s Excessive Deficit Procedure (EDP) in January 2014, less than a year after its EU accession. Asked to reduce this year’s budget deficit to 4.6% of GDP (from 4.9% of GDP last year), the Croatian government targets a fiscal adjustment worth USD 1.3bn (2.2% of GDP) this year that will mainly rely on short-term revenue-enhancing measures, rather than structural changes. Besides a controversial temporary transfer of pension savings to the state coffers, it intends to re-route two-thirds of profits of heavily subsidised state-owned enterprises back to the state budget and hike health care contributions, energy excises and taxes on lottery winnings. Meanwhile, costs savings should mainly be achieved through expenditure cuts on subsidies, investments, material and overtime salaries rather than job cuts in Croatia's oversized public sector. As far as structural reforms are concerned, a strategic investment law reducing red-tape and a welfare reform capping total benefits was enacted last year, while a labour market reform improving working hour flexibility and work force restructuring is currently being debated in parliament. However, given the immense scale of Croatia’s structural economic and fiscal problems, significantly more needs to be done to re-ignite economic growth and thereby halt Croatia’s disturbing public debt dynamics. Even though the European Commission expects that the public debt ratio stabilises at 69% of GDP next year in case Croatia succeeds in meeting the EDP deficit thresholds, the ongoing weakness of economic growth does not bode well in this respect. Moreover, considerable public opposition by vested interests can be expected once the government embarks on painful, yet urgently needed, structural reforms. Therefore, doubts about Croatia’s public debt sustainability among market participants may increase and preclude the country from financial market access. Thanks to the pre-financing of most of this year’s public funding needs and currently relatively liquid domestic capital markets, Croatia may yet be spared from market pressures in 2014. However, external assistance may be needed beyond 2014, unless major progress in terms of reforms and fiscal consolidation are achieved soon.
3. Finance minister fired amid corruption allegations
Croatia’s finance minister Slavko Linić was replaced by his former deputy Boris Lalovać in early May amid allegations that the minister, together with his already sacked assistant and the head of Croatia’s tax authority, may be complicit in a case of possible corruption. Last year, Mr Linić supported an arrangement that allowed the almost-bankrupt wood-working company Spacva to repay its tax debt by means of selling land to the state at an allegedly overvalued price. While the dismissal of the finance minister should not affect Croatia’s austerity efforts, the affair may deal a heavy blow to the cohesion and popularity of Prime Minister Zoran Milanović’s Social Democrat party (SDP) ahead of next year’s legislative elections. Despite his dismissal, the former finance minister still ranks among Croatia’s most popular politicians and benefits from substantial support within the SDP.
Croatia is a small open economy in Central Europe with a nominal GDP of USD 58bn (2013) and a population of 4.3m. In 2013, Croatia became the second former Yugoslav republic to join the European Union. Tourism constitutes the mainstay of the Croatian economy, as the country’s largely pristine coastline along the eastern shore of the Adriatic Sea and several historic cities attract about 11m foreign tourists, mainly from Austria, the Czech Republic, Germany and Slovenia, each year. Tourism activity is limited to the summer months, however, which contributes to considerable seasonality of economic growth and employment. Shipbuilding, while being on a downward trend as the European Commission has demanded the restructuring and privatization of the once heavily subsidized shipyards, still constitutes an important industrial sector, as does the production of pharmaceuticals. Agriculture still generates about 5% of GDP. Reflecting the absence of a sustainable growth model, Croatia’s economy has been in recession since 2009, while the country’s political elite has so far failed to implement structural reforms to improve Croatia’s relatively weak competitiveness and thereby boost its growth potential. Consequently, Croatian companies so far do not seem to be able to reap the benefits of EU membership, while the country’s exit from the Central European Free Trade Agreement (CEFTA) has negatively affected its access to markets in other former Yugoslav republics. High and mainly euro-denominated private and public debt levels constitute another structural weakness, as these expose the country to a marked depreciation of the local currency. So far, however, relatively ample foreign exchange reserves have helped the central bank in stabilising the exchange rate. Meanwhile, the government’s reluctance to embark on fiscal consolidation and structural reforms have ensured political stability. However, given the need to implement painful policy measures soon, the risks of public unrest will increase in the near future, as vested interests will defend their privileges.