76218 Croatia: a Strategy for Smart, Sustainable and Inclusive Growth Sanja Madzarevic-Sujster unemployment. At the end of 2011, Croatia’s GDP per capita (in purchasing power terms) declined to 61 percent of Key Messages1 the EU27 average, a loss of 2 percentage points since 2008.  Croatia’s current economic challenges include Indeed, sluggish growth and slow reforms have pushed sluggish growth, excessive public spending, high down Croatia’s competitiveness rankings, as measured by unemployment, and a deteriorating external the World Economic Forum and the World Bank’s Doing environment. Business indicators.  Expenditure-based fiscal consolidation is therefore The near-term growth outlook suggests that Croatia faces an urgent priority for Croatia to create future space another recessionary year, with demand for Croatian goods for growth-enhancing spending. and tourism services uncertain and limited prospects for foreign capital inflows. Feeble growth and weak balance  The country’s incomplete structural reform agenda sheets – on the part of the government, financial needs attention and action to promote greater institutions, and individual households – are combining to competitiveness and a shift to productivity-based, exacerbate the downturn. If the private sector-led growth. recovery continues to lose Croatia should act momentum, balance sheet decisively to set  Croatia also faces the strategic challenge of maximizing the benefits of European Union (EU) problems would worsen and national targets for membership, especially in terms of access to markets fiscal sustainability would expanding or and the use of EU Structural Funds, requiring deteriorate further. improving structural changes in the social sectors, education employment, In view of this worsening system, and business environment. economic environment, signing business innovation, the EU Accession Treaty and education quality, Croatia: Effective Action Required social inclusion, and becoming an EU member present Croatia currently faces several critical economic challenges. vital opportunities for Croatia to energy efficiency. The country’s new government has taken office at a time address its economic challenges when fast convergence with European Union (EU) member and build a competitive economy. The continued economic states is burdened by an external environment that has uncertainties, coupled with Croatia’s high debt overhang, worsened and will likely remain uncertain – at best – for the demand policies that will protect macroeconomic stability foreseeable future. World financial markets are currently in the near term and improve competitiveness over the risk-averse due to the sovereign debt crisis in the Eurozone medium term. Although fiscal consolidation is clearly the economies, and financing for emerging markets will main economic challenge in the near term, with a poverty continue to be scarcer and more expensive. Croatia now has rate of roughly 14 percent and 40 percent youth no option but to use its own resources more efficiently and unemployment, jobs, productivity, and social cohesion must to rely on domestic savings for growth. also be in focus. Croatia should therefore act decisively to set national targets for expanding or improving The new external challenges have arisen just as the Croatian employment, business innovation, education quality, social economy was making a fragile recovery and dealing with inclusion, and energy efficiency, all of which will require slow export growth, low investment, and persistent concerted government efforts to implement essential structural reforms. Policy responses must be both immediate 1 This Knowledge Brief is based on a series of policy notes prepared by and resolute. the World Bank for the Government of Croatia. ECA Knowledge Brief Table 1: Croatia: Selected Macroeconomic Indicators 2007 2008 2009 2010 2011 2012e 2013p National accounts (real growth rates) GDP 5.1 2.1 -6.9 -1.4 0.0 -1.8 0.8 Domestic demand 6.2 3.1 -10.2 -3.7 -0.3 -2.6 0.8 Labor market Unemployment rate (LFS) 9.6 8.4 9.1 11.8 13.5 13.8 14.0 Consumer Price Index (period average) 2.9 6.1 2.4 1.1 2.3 3.4 3.2 Exchange rate HRK/EUR p.a. 7.3 7.2 7.3 7.3 7.4 7.5 7.5 Government finance (% of GDP) Revenues 40.2 39.7 39.2 38.1 37.1 37.8 37.7 Expenditures 42.8 41.3 43.2 43.8 43.6 41.3 41.9 Broad deficit -2.6 -1.6 -4.0 -5.7 -6.5 -3.4 -4.2 Broad primary deficit -0.9 -0.2 -2.3 -3.7 -4.3 -0.9 -1.2 Public debt and guarantees 41.5 42.3 51.4 60.5 64.7 67.8 67.9 External sector (% of GDP) Current account balance -7.2 -8.7 -4.9 -1.6 -0.8 -0.9 -0.9 Gross external debt 77.7 83.6 104.4 103.7 94.7 98.7 98.0 Monetary (% rate of change) Broad money 18.3 4.3 -0.9 4.4 3.5 2.5 3.9 Private sector credit 15.0 10.5 -0.6 6.9 5.4 -0.4 3.0 Note: e-estimate, p-projection Source: CNB, Ministry of Finance, CROSTAT, World Bank calculations Fiscal Consolidation Urgently Needed required by the country’s Fiscal Responsibility Law) is thus urgently needed to reduce borrowing requirements and help Croatia’s past pro-cyclical fiscal policy has left it with large make debt more sustainable. macroeconomic imbalances. A growth model based on easily obtainable credit and domestic demand – and only The Risks of the Present Course limited progress on improving competitiveness – is proving The economic consequences of the country’s economic unsustainable. Market confidence in Croatia deteriorated policies have unfortunately left only a limited number of sharply in 2008 as the financial crisis broke, thanks to past policy responses. Clearly, fiscal consolidation is the most powerful Clearly, fiscal current account deficits that averaged 6 percent of GDP, external debt that equaled the GDP, and exposure to interest way to address the vulnerability. consolidation is the and exchange rate risks. In the three subsequent years, real While Croatia’s recent most powerful way GDP fell by over 10 percent, led by drops in investment and consolidation efforts have slightly to address Croatia’s private consumption. Revenue losses and inflexible reduced public spending to 41 vulnerability. spending structures widened the general government deficit percent of GDP, the level of public to above 5 percent of GDP, with public debt, including the expenditure must be curbed further. The risks of failing to stock of government guarantees, widening sharply to above act are clear: 60 percent of GDP.  Financing such high levels of spending is challenging After three years of recession, investors today view the when a country’s real economy is weak and its informal resilience of the Croatian economy as weak. After losing its economy notably large (Croatia’s is estimated at 15 investment grade credit rating by two rating agencies (S&P percent of GDP). In the last three years, when off- and Moody’s) in January 2013, spreads on credit default budget spending is included, the fiscal deficit has swaps are among the highest among emerging markets. In a reached close to 6 percent of GDP. With the callable more protracted recession, further revenue government guarantees, public debt came close to the underperformance is likely. Moreover, because of Croatia’s statutory limit of 60 percent of GDP, above which high volume of external debt, any adverse external financial public debt is generally considered to be of high risk. shocks will be transmitted faster and with greater intensity. For a country at Croatia’s level of development, a Transmission channels are likely to be a higher cost or ceiling closer to 40 percent would be advised. tightened access to financing in the short and long term,  During 2010-2012, the Croatian government was forced either of which could negatively affect the performance of to borrow an average of 12.5 percent of GDP annually the Croatian economy. Expenditure-based consolidation (as to refinance old debt and cover the deficit. Past debt ECA Knowledge Brief Table 2: Europe 2020 Targets, Croatia and the EU27 Headline Targets Indicators EU27 Croatia 2010/2009 75% of the population aged 20–64 should be Employment rate by gender, age group 20 – employed. 64 68.6 58.7 3% of EU GDP should be invested in R&D. Gross domestic expenditure on R&D 2.01 0.84 Greenhouse gas emissions should be reduced by 20% compared to 1990. Greenhouse gas emissions, base year 1990 83.0 99.1 The share of renewable energy sources in Share of renewables in gross final energy final energy consumption should rise to 20%. consumption 10.3 8.6 Energy efficiency should % increase by 20%. Energy intensity of the economy 165.2 284.3 The share of early school leavers should be Early leavers from education and training by under 10%; at least 40% of those 30–34 gender 14.1 3.9 should have completed tertiary or equivalent Tertiary educational attainment by gender, education. age group 30–34 33.6 22.6 People at risk of poverty or social exclusion, % 16.4 20.6 Poverty should be reduced by lifting at least People at risk of poverty before social 20 million people out of the risk of transfers, % 25.7 25.2 poverty or exclusion. People at-risk-of-poverty before social transfers, % 25.7 25.2 Source: Eurostat, CROSTAT. could become a significant problem unless Croatia can health spending alone, which absorbs roughly 7.8 percent of reassure investors by implementing a credible reform GDP, Croatia tops the EU. program that puts the country on a more sustainable In short, fiscal consolidation should act to safeguard and footing. support future growth by shoring up fiscal sustainability and  A rise in contingent liabilities (such as guarantees to creating the fiscal space to support private sector-led growth shipyards) and nondiscretionary spending, the impact of and build fiscal buffers against future shocks. Additional an aging population, and the present lack of space for government efforts should work to shift growth, support job counter-cyclical policies all call for a fiscal buffer. creation, promote the potential of sustainable and green  The current tax burden is the second highest in the growth, and stimulate the private sector to innovate and EU10, totaling about 37 percent of GDP. create new technologies.  Croatia currently lacks the fiscal space to cofinance EU- funded projects, which will increase in availability Unfinished Reform Agenda sevenfold compared to current levels. Since EU contributions are fixed but receipts of EU funds depend Accelerating economic recovery requires Croatia to on successful expenditures, it is imperative that this complete its currently unfinished structural reform agenda fiscal space be created. and shift to productivity-based, private sector-led growth. Before the global crisis, Croatia had high and sustained An ambitious path of fiscal consolidation is needed also to economic growth that, combined with a decline in the achieve a balanced budget over the business cycle. This population, resulted in an increase in per capita income means reducing spending and increasing tax compliance by from 1994 through 2008 – a growth achieved mainly over 5 percentage points of GDP. Such a stance would through the expansion of aggregate demand and the non- prepare Croatia to meet the requirements of the EU’s tradable sector (particularly real estate). The result was Stability and Growth Pact and help it avoid the stringent large current account deficits and excessive dependence on Excessive Deficit Procedure criteria upon EU accession. foreign savings, even as investors were becoming more Government subsidies, the public sector wage bill, and risk-averse and financial resources scarcer. At the same categorical benefits – including the exceptionally high time, this growth did not reach the country’s most pension bill – are just some of the areas in need of more vulnerable persons; at the onset of the 2008 crisis, Croatia’s rationalized spending. At 2.4 percent, subsidies to railways, poverty rate was still stubbornly high at 11 percent. shipyards, and agriculture are fivefold those of the EU15, Reducing the role of the state and creating the space and the public sector wage bill stands at 10.6 percent of GDP, enabling environment for the private sector are urgent and privileged pensions currently absorb 1.9 percent of priorities to facilitate recovery and growth. Improving the GDP. To ensure long-term fiscal sustainability and improve investment climate by cutting red tape and strengthening the efficiency and effectiveness, reforms to the pension, health, rule of law would attract new entrepreneurs and foreign and social benefits systems are critical (see below). On direct investment (FDI); bring in new ideas, technology, and ECA Knowledge Brief know-how; and open new export markets. Past government railway companies needs improvement, including by setting policies, visible in soft-budget constraints and high appropriate track access charges. Croatia will also have to subsidization, limited enterprise restructuring and new make considerable and sustainable efforts to comply with business initiatives. There are over 600 companies in state the EU environmental and climate change/energy acquis, ownership, many of which could attract private interest and requiring it to rethink its financing model to incorporate needed investments for modernization and growth. The private participation and efficiently absorb EU funds. These government could also do more to: investments would need to be supported by utility sector  reform product market regulation governance reforms to reduce fragmentation and exploit  remove administrative barriers to investments economies of scale. In addition, although agriculture is vital  reduce the logistics costs in trade for economic development, its large environmental footprint  make the bankruptcy process more efficient should be reduced and farming systems made less  modernize contract enforcement and property rights. vulnerable to climate change. Reform Targets: Labor, Social Services, and Infrastructure Maximizing the Opportunities of EU Membership Croatia’s labor force participation rate is among the lowest EU membership generates both opportunities and in Europe. Labor market reforms must address this challenges. For Croatia, one strategic challenge is the need deficiency, which particularly affects older workers, prime- to create a competitive private sector, since recent events in age men (25–54), and youth, and be combined with the Eurozone suggest that access to a large market and the education and social sector reforms. The labor market needs implied political stability of EU membership are not to be more flexible to support sufficient in themselves to raise country competitiveness. In Croatia spends employment growth, currently at a more on health and low 59 percent compared to the order for Croatia to take advantage of a large market, social protection structural changes in social sectors, education, and the Europe 2020 Strategy target of 75 business climate are urgently needed. These measures are than many other percent. Labor market reforms all aligned with the Europe 2020 Agenda for Smart, countries in Europe. alone are not sufficient, however. Sustainable, and Inclusive Growth with which Croatia will The social protection system must have to comply after accession. also be revamped to incentivize seeking or getting back to work, and the education system made more responsive to Another crucial challenge and major priority for Croatia in changing labor market demand, including by producing the coming two–three years will be to create the fiscal space more well-trained, skills-appropriate graduates. to absorb EU funds and avoid being a net contributor to the EU. Upon accession, the EU Structural and Cohesion funds Creating more effective, better targeted, and fiscally available to Croatia will exceed €1.5 billion per year, but responsible social safety net is an urgent task. Although Croatia will be obligated to contribute about €600 million Croatia spends more on health and social protection than annually to the EU budget. Absorbing EU funds effectively many other countries in Europe, the overall level and and efficiently requires considerable preparatory work to quality of social services currently fall short of the needs of ensure that projects are ready for the influx, and the funds many Croatians. Moreover, the share of categorical benefits can assist Croatia in such critical sectors as transport and the and entitlements – which are not distributed according to environment, and support job creation through innovation income level – is high and the share of poverty-focused and the modernization of production. Despite the substantial programs relatively low. Rebalancing this mix would effort involved, the new resources represent a significant benefit both fiscal consolidation and also labor force and even historic opportunity for Croatia to confront and participation. The financial problems in the pension and manage its many economic challenges as part of a strategy health systems also weigh heavily on the national deficit to reestablish a successful economic path. and present growing concerns as the population ages. Reform of the health system, including further hospital About the Author rationalization, and intensified pension reforms will be Sanja Madzarevic-Sujster is a Senior Country Economist critical challenges. with the Poverty Reduction and Economic Management To build on its unique potential to become a regional Sector Unit of the Europe and Central Asia region of the logistics and distribution hub, Croatia has to modernize core World Bank. infrastructure: railways, energy, and utilities. The operational and financial performance of the national “ECA Knowledge Brief� is a regular series of notes highlighting recent analyses, good practices, and lessons learned from the development work program of the World Bank’s Europe and Central Asia Region http://www.worldbank.org/eca.