1. Croatia’s economy is in need of far reaching and challenging reforms to improve its weak macroeconomic outlook over the medium term. Structural weaknesses, reflected in low competitiveness and high underlying fiscal deficits will likely result in a protracted period of slow growth and rising debt. Given the stable exchange rate policy, which reflects high euroization and foreign debt levels, the required improvement in competitiveness can only be achieved through internal adjustment. This entails maintaining inflation and/or wage growth relative to productivity below that of trading partners for a sustained period of time. To achieve price and cost adjustment, complementary macro-critical reforms are needed in the labor market, public administration, pensions, health care system, and privatization. Successful implementation of these reforms, which relies on building a broad-based consensus, would bring significant future benefits to the people of Croatia in the form of higher economic growth, job creation and improved standards of living. This would also allow the economy to reap the maximum benefits of EU accession.
What needs to be done? Full and speedy implementation of structural reforms outlined in the Economic Recovery Program (ERP) to boost competitiveness and spur growth
2. The ERP represents a commendable effort in diagnosing the underlying structural weaknesses and effectively outlines many of the reforms needed to tackle these problems.
Implementation has made progress in two important areas:
• Labor force participation. The harmonization of retirement age for women and men, increased penalty for early retirement, introduction of bonus for late retirement, decreased unemployment benefits beyond 90 days of joblessness, and incentives for job training, should contribute to increasing labor force participation. However, the changes in the pension parameters fall short of those set out in the ERP, and are not sufficient to ensure the sustainability of the pension system.
• Private sector participation. Streamlining of business registration, reduction of non-tax revenues (which are an administrative burden on the private sector), and judicial reforms to strengthen contract enforcement and bankruptcy procedures for companies, will help enhance private sector participation in the economy. Nevertheless, much needs to be done to improve investor confidence and unleash the true potential of the private sector (including reforms specified below).
Implementation of other key reforms is required in the following areas:
• Ensure sustainability of pension and health expenditures. Measures to ensure sustainability of the pension system, including gradually harmonizing pensions granted under different terms, and further rationalization of the hospital network will be important.
• Streamline and improve efficiency of the public sector. While measures have been taken to consolidate public administration agencies, reforms to reduce public sector employment and cut subsidies to enterprises need to be accelerated. In addition, minority and majority non-strategic government-owned companies should be privatized.
• Enhance labor market flexibility. To improve competitiveness, greater flexibility in employment and wage agreements is needed to ensure that wage growth does not exceed productivity growth. Reforms have yet to commence in this key area.
• Improve the fiscal policy framework. Given the stable exchange rate, fiscal policy is the main macroeconomic policy tool. The mission welcomes the authorities’ intention to put in place a fiscal responsibility law. To ensure that such a law puts Croatia's public debt on a declining path and creates adequate fiscal space, it would be important to implement expenditure consolidation prior to its adoption. In addition, it should target a cyclically-adjusted balanced budget once the initial consolidation is completed. Setting the target on overall deficit on ESA95 basis would help ensure consistency with the rules under the Stability and Growth Pact.
Near term outlook: sluggish recovery with weak medium-term prospects
