On June 24, 2015, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with the Republic of Croatia.

After six years of persistent recession, Croatia’s economy is showing first signs of recovery. Robust retail sales and Value-Added Tax receipts suggest that private consumption has bottomed out. Employment has stabilized and corporate profits are recovering. Tailwinds from a favorable external environment have helped, notably lower energy prices, stronger euro area growth, and ample domestic and external liquidity that contain debt servicing costs. However, stronger exports, industrial production and foreign direct investment also suggest that the economy’s shift from inward orientation towards the tradable sector is making progress.

This said, the economy is not yet out of the woods, with several structural impediments weighing on the recovery. Corporate investment is still contracting, as many companies struggle with high debt levels. State-owned enterprises continue to tie up a disproportionate part of economic resources. Together with a chronically weak business environment and relatively high wages, this increases the costs of operation for private corporations, complicating the strengthening of competitiveness and the re-orientation toward markets with growth potential. Policy uncertainty—especially high in face of parliamentary elections that are due within the next nine months—weighs on sentiment.

In the wake of the long recession, large fiscal vulnerabilities have built up. Public debt has increased from 35 percent of GDP in 2008 to 85 percent at end-2014, reflecting fiscal deficits averaging almost 6.5 percent of GDP since 2009—due in part to the assumption of debts from state-owned enterprises—and the economic contraction. At around 20 percent of GDP, public annual gross financing needs are large.

Still, macro-economic and financial risks appear contained. The government covers more than 80 percent of financing needs from domestic sources, notably banks. Risks of capital outflows and currency instability are contained by prudential regulation compelling banks to maintain large liquidity surpluses in Croatia, the absence of foreign investors in the domestic currency securities market—limiting the risk of a destabilizing sell-off—and thin futures markets that render it difficult to build up positions against the kuna.

For 2015, the economy is projected to grow by 0.5 percent. Domestic demand is expected to stagnate as two effects broadly offset one another: continued corporate balance sheet repair constraining investment, and lower oil prices that support consumption. Net exports are expected to make a modest positive contribution to growth. From 2016, a more robust recovery is expected, as better corporate profits facilitate dealing with high debt levels, exports strengthen further in line with the external environment, and the government increasingly offsets a contractionary impulse from fiscal adjustment with absorption of European Union structural and cohesion funds.

Executive Board Assessment²

Executive Directors welcomed signs that Croatia’s economy is recovering, supported by a favorable external environment. Directors noted, however, that fiscal vulnerabilities, incomplete corporate balance sheet repair, and structural weaknesses pose risks to the outlook. In particular, they underscored that the severity of the last recession points to the need to address decisively the entrenched rigidities that still hamper the economy’s growth potential and resilience.

Directors commended the authorities for the progress made on structural reforms, but noted that key issues remain to be tackled. Specifically, the large and inefficient state owned enterprise sector is in need of overhaul and the overlap between different layers of government undermines the business climate. Directors agreed that prompt actions on these fronts should top the policy agenda for the period ahead.

Directors welcomed Croatia’s ongoing fiscal consolidation under the European Commission’s Excessive Deficit Procedure. They encouraged the authorities to flesh out a comprehensive medium term plan of fiscal adjustment that focuses on growth friendly measures. In particular, Directors recommended a shift to less distortionary taxation, including a modern property tax. They also saw a strong case for rationalizing transfers and subsidies while protecting public investment. Directors welcomed the adoption of EU standards for fiscal statistics, which will allow a more accurate reflection of risks to the government’s balance sheet.

Directors considered that, in view of the prevalence of euro denominated loans, safeguarding the kuna-euro exchange rate anchor remains without a viable alternative for monetary policy. They underscored, however, that the quasi-peg requires adequate international reserves and a more active use of policies to safeguard competitiveness.

Directors commended the central bank for maintaining financial stability through a long recession, but stressed that continued supervisory vigilance is needed in light of the risks associated with elevated nonperforming loans. Directors looked forward to a prompt resolution of the issues related to Swiss franc denominated debt in a manner that would safeguard financial and monetary stability. Addressing these vulnerabilities is also key to removing impediments to new bank credit.

It is expected that the next Article IV consultation with the Republic of Croatia will be held on the standard 12-month cycle.