Croatia: successful reforms much needed but unlikely
Croatia’s short term outlook has improved on the back of higher private consumption, investment and exports. Unfortunately, chances of successful structural and fiscal reforms by the new government are dim, due to its small and likely unstable majority.
Strengths (+) and weaknesses (-)
(+) Favourable geographic location and EU membership
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 centers 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 necessary structural reforms that could boost its competitiveness and growth potential. An obstructive bureaucracy, cumbersome legislation, and rigid labour markets undermine the country’s business climate.
(-) Elevated 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 refinancing risks. Public debt dynamics remain worrisome, as the government fails to rein in budget deficits.
1. A modest recovery of economic growth…
After six years of recession, 2015 finally marked a return to growth, although modest in size and helped by positive external circumstances (figure 1). Modest growth is also expected for 2016 and 2017. The export sector contributes positively to growth, in particular the services sector as tourism benefits from instability in competitor markets such as Greece and Turkey. Although the export of goods has shown a rising contribution to GDP, Croatia’s low competitiveness in terms of costs but also of non-cost factors such as quality and the integration in global value chains have restrained further export gains from EU accession so far. The government, facing the challenge of reducing its long-standing budget deficits, has very little scope for contributing to growth. While monetary policy options to support growth are also constrained by the currency’s quasi-peg to the euro and a high level of euroisation in the banking sector, low inflation has helped preserve purchasing power. This may have provided a gentle push for consumer confidence, which according to National Bank of Croatia data has been showing some recovery lately. Improving consumer confidence is reflected in increasing private consumption, contributing positively to GDP growth. Gross fixed investment has also finally picked up after years of decline. As a result of already high corporate sector leverage, credit growth has remained subdued in recent years, although this is likely also related to stubbornly high non-performing loans (17% of the total loan portfolio): even if about half is provisioned for and capital buffers are generally sufficient to cover the rest, they restrain banks’ ability to expand their balance sheets. In this context, it is encouraging that banks have been able to remain profitable in recent years, with the exception of 2015, when they had to take losses from obligatory conversion of Swiss franc household loans into euro.
2. ... is insufficient to restore fiscal sustainability in the absence of substantial structural reforms...
Croatia’s public debt reached an unsustainable 89 percent of GDP in 2015 (figure 2), after the government budget showed average deficits of 4.9 percent of GDP in the past decade, while average real economic growth was nearly zero (0.3 percent) over the same period. About 80 percent of public debt is financed domestically, implying modest direct vulnerability of public finances to external market pressures. Still, almost 80 percent of public debt is denominated in foreign currency, but the quasi-peg to the euro to some extent shields public finances from currency risk. In January of this year, a new government was installed: a coalition between the center-right Croatian Democratic Union (HDZ) and the small and the rather undefined Bridge party (‘MOST’). This government has announced ambitious goals for increasing economic growth and restoring fiscal sustainability. But given their narrow and likely unstable majority in parliament, uncertainty looms large as to what extent the government will be successful in realising its goals. Absent successful structural reforms, which would improve the competitiveness of Croatia’s private sector, growth is therefore likely to remain modest at best over the medium-term.
3. … amidst external vulnerabilities.
Gross external debt is high at around 105% of GDP, while the share of short-term debt is modest at 8% of gross external debt. Nevertheless, gross external debt payments for 2016 are projected by the Croatian National Bank to amount to EUR 11bn in 2016, or roughly 25% of GDP, demonstrating Croatia’s vulnerability to a change in external investors’ risk sentiment. Foreign exchange reserves (at 130 percent of debt service cover) and the current account surplus provide a buffer. But taking into account the necessity to maintain the quasi-peg to the euro, which could demand selling FX reserves in case of currency pressures and at the same time limits possibilities for external devaluation as a means of adjustment, reserve adequacy must be assessed as sufficient, but not ample.
Croatia is a small open economy in Central Europe with 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 annually, mainly from Austria, the Czech Republic, Germany and Slovenia. 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 4% of GDP. Reflecting the absence of a sustainable growth model, Croatia’s economy has been in recession between 2009 and 2014, 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. High and mainly euro-denominated private and public debt levels constitute another structural weakness, as these expose the country to a deterioration of investor sentiment. So far, however, sufficient foreign exchange reserves have helped the central bank in maintaining the Kuna’s quasi-peg to the euro. Meanwhile, the previous 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.