"Croatia is in its fifth year of recession" and the IMF staff expects a real GDP decline of about 0.75% "amid still contracting consumption and private investment."
"A modest recovery is projected for 2014, reflecting an improved external outlook and higher publicly funded investments. Risks to the recovery remain considerable, however," said the statement after the staff team's visit from October 30 to November 6.
The IMF team, led by Johannes Wiegand, met with representatives of the government, the central bank, the business community, unions, and the international community.
"Slower-than-expected euro area growth could continue to act as a drag on external demand. Tighter global financing conditions and/or an increased country risk spread could raise financing costs of the sovereign and the private sector. Delays in structural reforms could undermine business sentiment and curtail investment. Upside risks include a possible improvement in sentiment due to EU accession," said the statement.
"Medium-term growth prospects depend on efforts to enhance competitiveness. Domestic demand is expected to recover once private sector debt levels normalize, although the timing of this normalization remains uncertain. However, Croatia will seize its full growth potential only if it boosts exports and becomes a more attractive destination for investments. Improvements in competitiveness require structural reforms," the statement added.
"Faced with protracted economic contraction, the government has struggled to contain the fiscal deficit in 2013, following good efforts at consolidation in 2012. At this stage, the 2013 general government deficit is projected at about 5.5 percent of GDP (cash basis), compared to a planned deficit of 3.6 percent. As a result, public debt as a share of GDP is expected to surpass 60 percent before end-year," the staff team concluded.
The widening in the deficit reflects weaker growth than originally foreseen and corresponding revenue shortfalls, higher interest payments stemming from the assumption of debts from restructured and/or privatized publicly owned companies, and clearance of health sector arrears, the statement said, adding that a "similarly large deficit is foreseen in the government's Economic and Fiscal Policy Guidelines 2014–16, although this number may change with the budget."
"The imminent excessive deficit procedure (EDP) by the European Commission could provide a much needed fiscal anchor, provided it is backed by binding policy commitments. In designing the speed of adjustment under the EDP, a sensible balance will need to be struck between establishing policy credibility on the one hand, and avoiding excessively rapid tightening in an environment of private sector debt reduction on the other. Elements of adjustment could usefully include better targeting of subsidies and social assistance, pension reform, streamlining VAT and strengthening property taxation," the statement said.
"Monetary policy is anchored by the euro exchange rate, given high eurozation and, correspondingly, contractionary balance sheet effects that a devaluation could trigger. Within the constraints set by this monetary framework, the central bank has appropriately sought to maintain accommodative domestic currency liquidity conditions. The banking sector has retained ample capital and liquidity buffers, although private sector credit is stagnating and non-performing loans have increased to around 15 percent," the statement said.
It added that "the central bank is using macro-prudential instruments in combination with credit support schemes sponsored by the state development bank to boost credit growth. These efforts are welcome, provided the associated contingent fiscal and bank credit risks are managed carefully."
The IMF staff team also said that the authorities "have made welcome progress with structural reforms, but an intensification of these efforts is warranted. Specifically, the government has eased hiring restrictions, reduced incentives for early retirement, introduced an out-of-court settlement procedure for insolvent corporations, and restructured several publicly owned enterprises. There have also been commendable advances with privatization. However, further steps are needed to increase the labor market's capacity to adjust, enhance labor market participation - including through accelerating pension reform — safeguard a predictable regulatory environment, and strengthen the business climate."