With unfavourable external conditions and subdued domestic demand, Croatia can expect a further contraction of GDP by 1.5% this year and modest growth of 0.75% in 2013, and unless barriers to investment and employment growth are forcefully addressed, potential growth will remain modest, the Executive Board of the International Monetary Fund said in a report on Tuesday after concluding the Article IV consultation with Croatia last week.
"Croatia is experiencing a prolonged recession reflecting subdued domestic demand, lackluster competitiveness, and a difficult external environment. Short-term growth prospects remain weak and downside risks prevail, while structural impediments hamper medium-term growth," IMF executive directors noted in their assessment, underscoring the importance of advancing with policies and structural reforms to boost growth and reduce vulnerabilities.
The IMF recalled that the Croatian authorities had adopted a comprehensive structural reform program in August and had launched a significant consolidation this year aimed at reducing the deficit from 5.2% of GDP in 2011 to 4% of GDP in 2012.
Directors welcomed the authorities' commitment to fiscal consolidation and the reduction of expenditure in 2012. "While they recognised that fiscal consolidation is particularly challenging at the current juncture, they underscored its necessity to restore debt sustainability, satisfy the requirements of the Fiscal Responsibility Law, and retain market access. Directors therefore saw a need to continue a gradual but steady expenditure-based consolidation in 2013 and well into the medium term, while protecting capital spending. Directors also encouraged the authorities to persevere with their efforts to rebalance the tax structure away from labour in a revenue-neutral way."
Directors welcomed the recent adoption of the government's structural reform program, "which makes a good start on the road to restore competitiveness and spur growth." They encouraged the authorities to develop specific policies and prioritise measures, focused on raising labour force participation, enhancing labour market flexibility, reducing barriers to market entry, and fostering competition.
Directors welcomed the increased exchange rate flexibility of recent years, but generally agreed that the broadly stable exchange rate framework has served Croatia well and that excessive exchange movements would be harmful given the high degree of euroisation and the sizeable external debt.
In order to build further an important buffer against external shocks, directors recommended that the central bank continue to gradually accumulate international reserves.
Croatia's financial sector appears well-capitalised and resilient to shocks, but faces risks related to potential further deterioration of asset quality, indirect credit risk stemming from vulnerable borrowers, and sizeable dependence on parent banks for funding, so IMF directors stressed the importance of maintaining high statutory capital buffers, ensuring adequate provisioning for non-performing loans, further strengthening financial supervision and regulation and cross-border supervisory cooperation, and closely monitoring liquidity and credit developments.
