Economic prospects are weak and risks large, Croatia is in recession, gross domestic product is set to contract further by 1.5% in 2012, only modestly picking up by 0.75% in 2013, so "far-reaching reforms are needed to return to robust medium-term GDP growth and reverse the sharp increase in unemployment and a strong reform agenda to address these problems is long overdue," the mission said in Tuesday's statement.
"The structural reform program –– critical for resuming growth and raising the economy's potential –– is being launched, but reforms in important areas remain to be fully developed and articulated to the public. Key policy priorities are to design, announce, and implement a credible and balanced fiscal consolidation package to ensure medium-term fiscal sustainability; initiate far-reaching structural reforms to improve competitiveness and growth prospects; and maintain financial stability by containing funding and credit risks," the statement said.
"Vulnerabilities remain high. Debt rollover risks are significant with external, mostly private debt of about 100 percent of GDP, and an external financing requirement of 30 percent of GDP in 2012," it added.
"The budget deficit is high and public debt is rising fast. Although bond and CDS spreads have declined lately, influenced by external factors and Fitch's raising the sovereign outlook to stable, market confidence remains fragile. Large liabilities in foreign currencies expose corporate and household balance sheets to exchange rate shocks," according to the mission.
"Slow adjustment to the post-crisis environment has exhausted the government's fiscal space, calling for significant and sustained fiscal consolidation to keep public debt under control," the statement said, adding that vested interests' resistance to reforms also complicated the process. "Policy makers and social partners should recognize the major challenges Croatia is facing and swiftly agree on decisive actions to address them."
Policies should continue to focus on rationalising bloated public employment and remuneration, revamping the unaffordable pension and health systems, and reducing overly generous subsidies, the statement said.
The mission expects the 2012 budget deficit target amounting to about 4% of GDP will be reached, provided the collective labor agreements for public servants are amended as the government proposes. Additional efforts are needed in 2013, targeting a headline deficit of no more than 3% of GDP.
The authorities' efforts to rebalance, in a revenue-neutral way, the tax structure away from labor are welcome and should be pursued further.
"To create space for further reduction in labor taxation, the mission recommends increasing the zero VAT rate on certain domestic sales –– an EU requirement –– to 10 percent rather than the minimum admissible 5 percent, with part of the additional revenue used to augment targeted social assistance to the most vulnerable," the statement said, adding that introducing "a modern value-based property tax, accompanied by transferring additional spending responsibilities to local governments, would also help in this regard."
The planned large investment projects by state-owned enterprises could support growth, but should be subjected to a careful cost-benefit analysis. The large projects in the energy sector and water supply, as well as public-private partnerships in education and health care could underpin growth, reduce costs, and raise the economy's capacity in the medium term, but they should be accompanied by restructuring of the involved state-owned enterprises to ensure efficient implementation, the mission said, recommending a careful assessment of their benefits for long-term growth versus financial cost.
The statement said "only limited reforms have been launched to foster labor market flexibility, improve the business climate, and reduce the size of the public sector."
Far-reaching reforms are therefore needed to return to robust medium-term GDP growth and reverse the sharp increase in unemployment and a strong reform agenda to address these problems is long overdue, the mission said, adding that the government's structural reform programme adopted in August was a good start, "but many key reforms remain to be developed."
The mission recommends priority be given to reforms aiming to "boost work incentives via a faster increase in the retirement age for women to 65, a further increase to 67 for both men and women, higher penalty for early retirement, and tighter control over the apparently abused system of disability retirement."
The mission also recommends improving "labor market flexibility by reducing hiring and dismissal costs, including for poor performance, and allowing firms to opt out from onerous sector-level collective agreements, while ensuring that the envisaged single open-ended contract does not impede flexibility."
The mission said reforms should "foster competition and reduce barriers to market entry by relaxing the licensing and administrative requirements to open a business (notably at the local level) and speeding up privatization."