However, the IMF Mission warned about a large current account deficit and a high foreign debt, urging further fiscal consolidation.
Since 2004 the Croatian government "has put the fiscal deficit on a downward path, improving transparency and budgeting processes, and reduced quasi-fiscal activities. Meanwhile, steps were taken to bring the pension and health care systems closer to sustainability, and financial sector supervision has been strengthened," the Mission said in its report.
"Looking ahead, the beginning of EU negotiations and the successful completion of the screening process have boosted investment prospects. Absent negative shocks and slippages in macroeconomic policies, economic growth for 2007 and the medium term should remain solid, albeit lower than the highs of recent years. Meanwhile, inflation is expected to remain in check.
"That being said, a deteriorating current account deficit in recent years and a high level of external indebtedness leave no room for complacency and underscores the importance of continuing the fiscal consolidation effort," the report warns.
The current account deficit is expected to exceed 7.5 per cent of Gross Domestic Product (GDP) this year, with a clear risk that it will be even larger next year.
"At the same time, Croatia's gross external debt is high at over 80 per cent of GDP. The large external imbalance leaves the economy exposed to external shocks, potentially accentuated by an expected sharp drop in privatisation-related inflows after 2007.
"Moreover, a change in investors' sentiment toward emerging markets could lead to debt rollover and debt service difficulties. Being well aware of these risks, the government and the Croatian National Bank stepped up efforts to mitigate them in recent years. However, with elections in 2007, there is also a well-recognised risk of policy drift and rising populism in the formulation of fiscal policy," the report says.
The state is still overly present in the economy, the pace of key structural reforms is too slow, and conditions for doing business are less than satisfactory and hold the economy back, the Mission concluded.
"The state's presence in many aspects of economic activity remains significant and is reflected in one of the biggest governments in the region, high state aid in various forms, and a large public sector share of output (about 40 per cent of GDP, high relative to Croatia's peers in central and eastern Europe).
"While recent progress in some transition indicators has been significant, Croatia still lags behind in privatisation and the restructuring of state-owned enterprises," the Mission said, forecasting a potential growth rate of about 4.5 per cent, or somewhat lower.
In the section dealing with fiscal policy, the IMF Mission says that reducing the size of the government, undertaking further fiscal consolidation and enhancing the flexibility of fiscal policy are three essential and interrelated aspects of fiscal policy.
The government's overall fiscal strategy, which includes the targets for 2006 and 2007 and aims to reduce the fiscal deficit to three per cent of GDP this year and 2.8 per cent next year, was described as an important step in the right direction.
The report says that potentially serious concerns arise from fiscal policy for 2007. Spending pressures are mounting, and the recently approved increases of child and maternity benefits and free school textbooks add to expenditure at least 0.3 percentage point of GDP. Pressures to raise budgetary wages by more than the five per cent envisaged by the authorities and to boost pensions of post-1999 pensioners represent sizable fiscal risks.
"While achieving the 2007 deficit target of 2.8 per cent of GDP would no doubt be an accomplishment in the politically-charged atmosphere before elections, problems would be created in the out years if exceptional, temporary revenue increases (including, for example, a large Croatian National Bank profit transfer, and dividends from state enterprises) were to be used to fund additional, permanent expenditure commitments," the Mission says.
In the section dealing with monetary policy and the financial sector, the IMF says that the central bank's present monetary policy continues to contribute to macroeconomic stability, noting that financial vulnerabilities are related in particular to rapid credit growth.
The part of the report on structural policies highlighted the urgency of measures to improve the business environment and remove bureaucratic obstacles to economic growth. "The authorities should persevere with their long-standing reform agenda for remaining state-owned enterprises," it says.
The IMF Mission welcomed the forthcoming launch of the initial public offering for the INA oil company and the third phase of privatisation of the HT telecommunications company, and urged the sale of all other shares held by the Croatian Privatisation Fund.
The Mission has strong reservations about aspects of the new draft privatisation law, in particular about the planned employee stock ownership program (ESOP), estimating that it might deter potential strategic investors.