ZAGREB, December 11, 2018 - The Croatian authorities have skilfully utilised the economic upturn to reduce indebtedness and further build external buffers but important challenges remain for the Croatian economic policies such as the need to restructure public administration and make the pension and healthcare systems sustainable, a delegation of the International Monetary Fund (IMF) said on Monday, noting that the current economic situation provided a good basis for the necessary structural reforms.
The IMF staff were recently on a visit to Croatia as part of regular consultations under Article IV of the IMF's Articles of Agreement. Their closing statement was published on the IMF and Croatian National Bank's (CNB) websites on Monday.
"Macroeconomic developments have been positive. Growth continues to be strong, inflation benign, and unemployment has steadily declined. However, the labour participation rate remains low. The Croatian authorities have skilfully utilized the economic upturn to reduce indebtedness and further build external buffers. Yet, important challenges remain," IMF delegation says.
It notes that relatively low levels of public and private investments and the emigration of young people hamper medium-term growth prospects. "Emigration and population aging are generating labour shortages. They also challenge the long-term sustainability of the pension and the healthcare systems. This calls for a smartly focused transformation to a more dynamic economy, and a more efficient state," the IMF officials say, underlining as the most important "a sizable restructuring of public administration".
Durable fixing of the healthcare and pension systems are two of the other important issues to tackle, the IMF delegation says, noting that some welcome progress is being made on those fronts, but the momentum needs to be sustained. “Acting decisively now—under favourable conditions—would ensure higher living standards in the future," the IMF delegation says.
The IMF expects Croatia's economic growth to moderate gradually over the next few years, as the economy moves closer to its potential. However, there are negative risks to this outlook, mainly due to possible changes in regional and global economic and financial conditions. "Sustained strong growth is needed to catch up to the income levels of wealthier EU countries. Achieving this requires an infusion of greater dynamism and resilience to the economy."
Further integration into Europe via the entry into ERM II and the banking union will set the stage for the envisaged adoption of the euro. Yet, to enjoy the full benefits of the currency union, deeper structural changes are essential, as is continued careful management of the country's public finances, the IMF says.
"Today's economic conditions provide fertile ground for the needed structural changes. Such changes require up-front compromises from all stakeholders and the rewards are harvested with time, once the efforts bear fruit. Therefore, they have greater chances of success if initiated when economic conditions are improving, as they are currently. The authorities have made some progress with respect to the National Reform Programme, which covers a wide area of structural reforms. While welcoming this progress, we encourage the authorities to push forward a focused structural agenda with stronger impetus."
A more dynamic state can facilitate durable growth, the IMF officials say.
Compared with regional peers, Croatia currently has one of the largest expenditures on total public employment proportional to the size of its economy. Furthermore, many municipalities do not have sizable populations, making the scope significant to merge services thereby generating greater efficiencies. "Decisive progress with reforms in this area will free up funds for investment in infrastructure and workers. It will also lead to better services for households and businesses."
The new draft law on merit-based civil service employee compensation is a first step towards a more efficient public service. "If complemented with an appropriate reduction in total public employment expenditure, it could open the space for high performing public employees to enjoy higher wages."
New public employees can be hired where they are needed, for example to enhance administrative capacity to absorb EU funds.
The further easing of administrative, tax, and parafiscal fees, will also produce collateral benefits by improving the business climate, enabling higher private investment and more job creation, the IMF officials say, noting that reforms to judicial and legal processes are important to keep on the agenda.
The recently passed pension reform is an important step in putting the system more in tune with the reality of increasing life-spans, and to make it more sustainable and equitable across generations, says the IMF delegation.
"Reinforcing measures that discourage early retirement, increasing the statutory retirement age, and eliminating group-specific pension provisions sets the stage for further measures to improve the system's viability. Examining the underlying weaknesses of the second pillar of the pension system is rightly on the authorities' agenda. Without such measures, pensions are likely to decrease, directly affecting the standard of living of the elderly," the delegation says in its statement.
Employment has picked up notably over the last two years and the challenge is to sustain this expansion, says the delegation. Yet, the labour market participation rate remains one of the lowest in the EU. "Structural unemployment, especially among youth and women, is high. This calls for steps to improve education and training."
Labour market flexibility needs to be enhanced, but this needs to be done carefully. "It should not lead to a two-tiered system, wherein employers invest significantly less in workers on temporary contracts and offer them less security relative to those on open-ended contracts. Such a situation could encourage further emigration of the young, to the detriment of medium-term growth prospects. This situation would benefit neither employees nor employers."
Solutions that better balance the considerations of both employers and employees are needed. This requires innovative thinking and compromises from all stakeholders.
A solution could take the form of a "hybrid" between the current fixed and open-ended contracts for an initial probationary period, to be followed by mandatory conversion to the full open-ended contract, upon completion of the probation.
It could also take the form of encouraging qualified public-sector workers who are interested in private sector employment, but fear losing the relative safety of their jobs to try their hand in the private sector with suitable but temporary safeguards to induce some risk-taking, the IMF officials say.
"To be clear, any solution needs to be thought through in detail, but the scope for innovation exists. Given that currently there are labour shortages, this would be a good time to work on suitable solutions."
Measures to increase child care access would incentivize greater participation from women. Improved targeting of all social benefits to those who are most in need is also likely to induce greater labour force participation, reads the statement.
In a comment on Croatia's fiscal policy, the IMF delegation says that recent budget performance has been commendable. The first surplus since independence was achieved in 2017. A small surplus might also materialize in 2018, depending on the size of one-off expenditures related to shipyard guarantees, says the delegation.
It notes that its fiscal recommendations are motivated by two equally important medium-term goals—to rebuild room for fiscal policy manoeuvre that can be used in the event another recession hits the economy and to improve medium-term growth prospects.
"To achieve these results, we recommend steadily increasing the fiscal surplus towards 1 percent of GDP over the next five years, and thereby accelerating the reduction of public debt to below the Stability and Growth Pact (SGP) threshold of 60 percent of GDP by 2023. This would help to reduce the vulnerability to potentially negative changes in regional and global conditions. Our recommendations to strengthen the budget include a more growth-friendly composition of public expenditures, and a gradual shift to more stable revenue collection from a broader set of sources."
On expenditures, increasing public investment, reducing the total expenditure on public employment, and reforming social benefits to better target the most vulnerable in society, are the top priorities.
On the revenue side, recent gains need to be preserved, the IMF says.
"At the appropriately receptive time and with careful design and communication, the introduction of a modern property tax merits reconsideration. It can provide a more stable revenue base, make the system more progressive and fairer, and create room to reduce higher and distortionary taxes elsewhere. Yet, it needs to ensure that it does not place an undue burden on individuals who are cashflow constrained, such as those on a limited pension. Preparatory steps for possible future reconsideration dovetail with other reforms such as the ongoing modernization of the land registry and the cadastre."
As regards the health sector, the IMF delegation believes that health spending needs to be made more efficient, that administrative costs should be reduced and the quality of health services provided to citizens improved.
There is also a need to reduce the drain on the budget caused by health sector arrears, which the authorities are working towards.
It is encouraging to note the number of new entrants contributing to the healthcare system, and the reduction in the numbers of non-paying participants for supplementary benefits, although some of this is also due to emigration.
"Still, a more comprehensive transformation requires a more rational premium and co-payment structure, ensuring that exceptions are minimized to protect only the most vulnerable. As IT system improvements and more rigorous income-testing come onstream, more improvements should be possible."
The IMF also calls for enhancing governance and performance of state-owned enterprises (SOE).
"Persistent loss-making SOEs are a drain on the budget, taking up more in subsidies than they pay back to the state... Strengthening SOE governance and increasing accountability to their budgets would help improve their efficiency and discipline."
The IMF delegation concludes its statement by noting that the Croatian National Bank (CNB) continued to deftly navigate the environment of low interest rates and ample liquidity. "Going forward, the CNB will need to pursue policies, which will allow the economy to accommodate potentially tighter external conditions and harness inflation expectations."
The banking system is, on average, very liquid, well capitalized and profitable, the delegation says.
The non-performing loan ratio is declining, in part due to their sales to third parties. "Additional measures to prevent excessive household borrowing, e.g., more comprehensive debt service-to-income based measures, could be considered for introduction at the appropriate time, if real estate prices accelerate or high growth of cash loans persists."
Further corporate sector deleveraging would be welcome, including through making the bankruptcy procedures even more efficient, e.g., by facilitating out-of-court settlements.
"Despite recent changes in the bankruptcy legislation, consideration could be given to conducting a comprehensive review to ensure that the insolvency framework aligns with best practices," the IMF says.
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