CROATIA'S ECONOMIC OUTLOOK: NOT YET OUT OF THE WOODS

Croatia remains stuck in an unusually drawn out recession. The real GDP is projected to contract for the 6th consecutive year in 2014 (-0/6%). Unemployment has risen to 18 percent . Domestic demand remains depressed as corporations and households focus on reducing excess debt levels accumulated during the boom period in the mid 2000s. Exports and FDI are also feeble, reflecting poor trading partner growth and structural weaknesses. Macroeconomic policies that could revive growth rapidly are beyond reach. Fiscal policy has run out of space , and is now subject to the European Union’s Excessive Deficit Procedure. Monetary policy is constrained by the need to keep the kuna-euro exchange rate stable, so as to prevent a revaluation of euro-indexed debts.

External financing conditions have remained manageable thus far, but Croatia’s country risk premium has increased relative to peers. The kuna-euro exchange rate depreciated marginally in the past 12 months, consistent with the central bank’s use of the kuna-euro exchange rate as monetary anchor. The banking system has remained stable, liquid and, on average, well capitalized, despite the difficult economic environment.

Growth prospects remain subdued in the short term, but a gradual recovery is expected from 2015 with a GDP projected to reach + 0.7%

• Domestic demand remains weak, reflecting continued private sector debt reduction and the impact of fiscal consolidation. Exports, however, benefit from the pick-up in the euro area. Inflation remains subdued.
• From 2015 out forecast is for a gradual recovery, as the impact of private sector deleveraging will begin to recede. Croatia’s long-term potential growth is estimated at around 2 percent (2.3 percent in per-capita terms).
• Risks to the forecast are considerable and mostly to the downside. Fiscal adjustment could trigger a larger private demand compression than projected. Conversely, insufficient fiscal consolidation could trigger concerns about sustainability of the public finances and undermine investor confidence. Private sector deleveraging could remain a drag on demand for longer than projected. Finally, tighter global liquidity conditions and a re-pricing of risk could complicate external financing, affecting especially Croatian sovereign debt. On the upside, foreign direct investment could pick up more rapidly than foreseen, reflecting in part recent policy initiatives to facilitate investments .

Reviving Growth

With many of Croatia’s economic problems owing to the persistent economic contraction, reviving economic growth and generating employment is a high priority. To this end, both weak domestic demand and long-standing structural impediments to growth need to be addressed.

High private sector debt remains a key obstacle to the recovery. Paying debt down is a slow and painful process during which demand will remain subdued. Orderly debt restructuring for over-indebted corporations and households provide the main prospect for accelerating the normalization in demand. In this context, the corporate pre-bankruptcy procedure introduced in 2012—that has thus far enabled the write-off of corporate debts of about 2 percent of GDP—is a useful tool that should be strengthened, including by encouraging broad and balanced participation by creditors. In addition, the authorities may want to give consideration to a personal bankruptcy regime, while being mindful of fair burden sharing between debtors and creditors.