Unemployment is expected to remain high throughout 2011 and the Croatian government's intention to keep expenditure unchanged requires agreement and legislation to freeze wages and pensions, and fending off new spending pressure, the mission said in its concluding statement at the end of last week's visit to Croatia, as published on the Croatian National Bank website.

"Structural weaknesses, reflected in low competitiveness and high underlying fiscal deficits will likely result in a protracted period of slow growth and rising debt," said the statement.

The mission says a full and speedy implementation of structural reforms outlined in the Economic Recovery Program (ERP) is necessary. "The ERP represents a commendable effort in diagnosing the underlying structural weaknesses and effectively outlines many of the reforms needed to tackle these problems."

"Given the stable exchange rate policy, which reflects high euroization and foreign debt levels, the required improvement in competitiveness can only be achieved through internal adjustment. This entails maintaining inflation and/or wage growth relative to productivity below that of trading partners for a sustained period of time," said the statement.

"To achieve price and cost adjustment, complementary macro-critical reforms are needed in the labor market, public administration, pensions, health care system, and privatization," it added.

The IMF says much needs to be done to improve investor confidence, to ensure sustainability of pension and health expenditures, to streamline and improve the efficiency of the public sector, to enhance labour market flexibility, and to improve the fiscal policy framework.

"Measures to ensure sustainability of the pension system, including gradually harmonizing pensions granted under different terms, and further rationalization of the hospital network will be important," said the statement.

"Reforms to reduce public sector employment and cut subsidies to enterprises need to be accelerated (and) minority and majority non-strategic government-owned companies should be privatized."

In the near term outlook, the IMF expects a sluggish recovery with weak medium-term prospects.

The recovery is more delayed than previously expected and the mission forecasts a GDP contraction of almost 2 percent in 2010, "although the pace of decline appears to be moderating in the second half of the year on account of signs of improving consumer sentiment and a mild recovery in credit growth. Real exports remain feeble, reflecting low competitiveness and a narrow export base. As a result, Croatia is one of the few countries among its peers where output is still falling in 2010."

According to the statement, a return to positive but subdued growth is likely in 2011, when the mission projects growth of about 1.5 percent.

"Unemployment is expected to remain elevated through 2011, followed by a steady but slow decline thereafter."

The current account deficit is expected to narrow in 2010 to about 2.75 percent of GDP, but is projected to widen to close to 4 percent of GDP in 2011 due to increasing imports.

"External financing needs remain large over the near term, mostly reflecting the corporate sector's debt repayment, with external debt close to 100 percent of GDP," said the statement.

"Downside risks to the economic outlook are significant. These are linked to the large external financing requirement and the pace of private sector deleveraging. Furthermore, delayed fiscal consolidation may lead to higher risk premia and borrowing costs for both the public and the private sectors."

On the fiscal policy front, the IMF says stronger measures are needed to reverse the rise in public debt.

"Measures announced in the supplementary budget fell short of what was necessary to contain the deterioration in the fiscal position in 2010. Consequently, the fiscal deficit is projected to reach 5.4 percent of GDP in 2010 and the broader public sector deficit over 6 percent of GDP," said the statement.

"The supplementary budget did not incorporate the expenditure measures envisaged under the (ERP) and did not keep expenditures frozen as intended, due to concerns about the social impact. As a result, public sector debt is projected to increase to 40 percent of GDP, or about 55 percent of GDP including public guarantees."

"The expenditure freeze envisaged for the 2011 budget requires additional ex ante fiscal measures worth about 0.7 percent of GDP, including wage and pension freeze," the concluding statement said, adding, "Additional widening of the fiscal deficit could arise from a slower-than-expected recovery and higher-than-budgeted spending for called guarantees on the shipyards."