"The immediate policy priorities should include launching a credible medium-term fiscal consolidation to retain market confidence and restore debt sustainability," the IMF mission said in a concluding statement after visiting Croatia last week.

The mission urged acceleration of structural reforms to boost the export and growth potential of the economy. With current policies, it projected a GDP decline of about 1 per cent in 2012.

"Fiscal consolidation should aim at reducing mandatory spending. (...) Expenditure cuts should focus on reduction in public sector employment, wage moderation/freeze, further reforms of pension and health systems, and decrease in subsidies," the statement said.

The authorities should also prepare contingency measures in the event that additional spillovers from the euro area crisis erode revenues and financing. These measures should aim at further containing the public sector wage and pension bill, it added.

In this context, the fiscal consolidation envisaged in the 2012 Fiscal Guidelines, if fully implemented, would be a step in the right direction. If the envisaged spending cuts (amounting to 4.6 billion kuna) are executed in full and the planned changes in taxation are broadly neutral, the mission estimates that the 2012 deficit of the general government would be reduced by about 1 per cent of GDP to 4.6 per cent of GDP. However, changes to the legal and institutional frameworks are a prerequisite for full implementation of the spending cuts.

The mission encourages the government to urgently pursue these changes to avoid the risks of accumulating arrears or some expenditure measures being challenged in courts. The general government debt is estimated to reach 52 per cent of GDP by year-end (assuming the guaranteed debt of shipyards are converted into public debt in the course of the year), and general government debt including contingent liabilities would reach 67 percent of GDP. Furthermore, the investment projects by public enterprises financed by borrowing would increase the deficit of the broader public sector, while adding any associated guarantees to the existing stock of contingent liabilities, the statement said.

The envisaged 2012 fiscal consolidation measures should be framed within the context of a medium-term plan to give credibility to the Fiscal Responsibility Law. This requires preparing and legislating specific measures and policy changes to deliver the planned fiscal consolidation aimed at reducing mandatory spending. Such a plan should also include a clear strategy regarding the evolution of the tax system. In this regard, the proposed decrease in direct taxation (health contributions) and increase in indirect taxation (VAT) is broadly appropriate to reduce the labor costs and should help stimulate job creation, provided that it is revenue neutral. However, the compensation of lower income households for the VAT increase should be considered in the broader context of the entire tax-benefit system, it added.

The IMF mission believes that wage and structural policies should be accelerated to enhance growth potential.

"Croatia's export and growth performance is constrained by relatively high wages and pervasive rigidities. Labor force participation is low due to the generous social benefits system. The labor market is one of the most uncompetitive in the region and wages are high relative to income and productivity," the mission said.

Insufficient progress has been made in privatisation and enterprise restructuring, curtailing productivity growth and private sector development. As a result, the public sector remains large with intrusive regulations, and imposes cumbersome fees on the private sector.

The mission thinks that implementation of long overdue structural reforms is necessary to improve competitiveness and attain sustainable medium-term growth.

"First, an internal devaluation via reduction in prices and wages to more competitive levels is needed in light of the stable exchange rate regime, which would be costly to adjust given the economy's large net foreign currency exposure. Second, priority must be given to structural reforms aimed at (i) increasing labor market flexibility by changing labor laws to induce more competitive wage setting and by reducing hiring and firing costs; (ii) boosting labor force participation through reforms of the social protection system; and (iii) reducing public sector employment and improving efficiency."

Other critical actions include accelerating privatisation of companies with government stakes and further improving the business climate, including through elimination of non-tax fees, the IMF mission said.