Download DOC - World bank documents

Operation Name
Region
Sector
Project ID
Borrower(s)
PROGRAM INFORMATION DOCUMENT (PID)
APPRAISAL STAGE
Report No.: AB5118
Fiscal, Social and Financial Sector Development Policy Loan
(DPL)
EUROPE AND CENTRAL ASIA
General public administration sector (40%); General finance
sector (30%); Other social services (30%)
P117665
THE REPUBLIC OF CROATIA
Implementing Agency
Date PID Prepared
Date of Appraisal
Authorization
Date of Board Approval
H.E. Ivan Suker, Minister, Ministry of Finance
Katanciceva 5
Zagreb
Croatia
Tel: (385-1) 459-1258 Fax: (385-1) 492-2598
MINISTRY OF FINANCE
October 20, 2009
November 4, 2009
January 7, 2009
1. Country and Sector Background
Croatia enjoyed strong economic growth at above 4.2 percent on average before the global crisis
outbreak in late 2008. The growth was driven primarily by domestic demand boom, tourism and
large capital inflows and resulted in rapid convergence with the EU in per capita income terms.
The country’s GDP per capita, at PPS, stood at 63.6 percent of the EU27 in 2008. Strong growth
entailed substantial employment gains in the past with unemployment rates dropping to
historically low levels and employment increasing to 58 percent in 2008.
Influenced by the regional downturn, domestic demand and trade flows have declined abruptly in
the last quarter of 2008. Economic activity in Croatia declined by 6.5 percent on annual level in
the first half of 2009, which was the biggest decline since the country’s independence. A
confidence in the financial sector has been protected by the appropriate and timely response of
authorities. Following the central bank’s response to the liquidity squeeze, in October 2008 the
Croatian Government increased a household deposit guarantee to EUR 56,000 to secure
depositors’ trust and prevent a bank-run. A Stability Fund for non-bank financial institutions was
established to retain confidence in the financial system through smooth exit of illiquid funds.
These measures and well capitalized Croatian banks have prevented major adverse depositors’
and investors’ perceptions. However, unsurprisingly, nonperforming loans ratio increased to 6.1
percent by June 2009. All parent banks have extended significant new additional lines of credit
in late 2008 and continue to rollover their outstanding exposure on Croatian subsidiaries, but
have limited additional support in 2009. Banks are relying instead on their domestic and foreign
assets released by central bank measures, while deposit growth remains subdued. Lower demand
for loans as well as banks becoming more risk averse led to private sector credit crunch
(particularly evident in loans to households) starting in mid-2009.
With the above described economic developments, fiscal policy underwent a serious stress from
late 2008, as revenues underperformed due to the economic slowdown and imports’ decline. The
optimistic macro assumptions and the spending pressure from automatic stabilizers necessitated
several revisions of the 2009 budget. In the absence of budget revisions, general government
deficit would have widened to around 5.4 percent of GDP. Through a combination of politically
and socially challenging expenditure reduction, amounting to 2.1 percent of GDP and revenue
increase, amounting to 0.4 percent GDP, the consolidated general government deficit is set to
increase from 0.9 to 2.9 percent of GDP. Government efforts to bring public finances back to
sustainability secured timely and adequate financing strategy for 2009 and helped sustain macro
stability.
To respond directly to the current crisis challenges, an Economic Council was formed as
Government’s primary advisory body, consisting of business community, academia, unions,
financial sector representatives and government decision-makers. In April 2009, the Council has
proposed stabilization and anti-recessionary measures, adopted by the Government, which this
operation supports and, among else, relate to public finance consolidation and finance
management, as well as measures to support financial and social sector resilience.
2. Operation Objectives
The objective of the DPL is to support the authorities’ efforts in addressing the adverse impact of
the global crisis through (i) strengthened public finances; (ii) strengthened social sector
resilience, and (iii) enhanced efficiency and stability of financial sector.
3. Rationale for Bank Involvement
The Bank Group’s Country Partnership Strategy for FY09-FY12 was presented to the Board in
September 2008 and there are at least two goals of the CPS that the proposed DPL would
support. These are: (i) sustaining macroeconomic stability through enhancing the efficiency and
effectiveness of public finances and strengthening financial sector supervision; and (ii)
improving quality and efficiency in the social sectors.
4. Financing
A single-tranche Fiscal, Social and Financial Sector Development Policy Loan (DPL) amounting
to EUR200 million (equivalent of USD290 million).
5. Institutional and Implementation Arrangements
Successful implementation of the proposed reform program will require effective coordination
among various ministries and agencies, and between the Government and Bank. The
Government assigned the State Secretary of the Ministry of Finance to coordinate the DPL
agenda within the Government. The Government, led by the Prime Minister, will oversee the
whole reform effort and ensure prompt action on agreed reforms.
The reform program sets out qualitative and quantitative benchmarks and program targets. The
Bank team monitors and follows up on progress, and meets with Croatian authorities periodically
to discuss next steps.
6. Benefits and Risks
The benefits of the proposed DPL include: contribution to macroeconomic stability through (i)
containing fiscal deficit and public finance reforms, including through ensuring financial
sustainability of health and pension sectors, (ii) ensuring social sector resilience to mitigate the
social impact of the crisis through improved targeting of social and unemployment benefits, as
well as (iii) enhancing efficiency and stability of the financial sector.
A key risk affecting the proposed operation is that the economic downturn in the EU and
specifically in Croatia will be more severe and prolonged than currently projected. This would
strain further the fiscal performance, corporate sector and consequently the banks, as well as
could raise social tensions. Given Croatia’s heavy reliance on tourism revenues and exports to
Europe, it is vulnerable to any deterioration in regional stability or EU growth slowdown. Also,
given the high level of external debt, high degree of euroization of the Croatian economy and
large debt service requirements over the medium term, the Croatian financial sector remains
vulnerable to exchange rate risks and capital inflows’ slowdown.
However, DPL-supported fiscal consolidation efforts and public expenditure management
reforms are expected to mitigate risks related to regular debt servicing for the public sector even
in the case of a prolonged recovery. DPL-supported measures related to enhancement of
financial sector regulation coupled with the Croatian National Bank’s efforts to monitor foreign
exchange exposures of bank clients and strengthening supervision both of banks and jointly with
HANFA of non-banking financial institutions should alleviate risks for private sector refinancing
and lead to system resilience to larger shocks.
Political risks remain moderately high as the country has a coalition Government with a slim
majority in Parliament, while several of proposed reforms are ambitious and politically
challenging. With presidential elections scheduled for late 2010, a risk of contemplation and
adoption of fiscally less sustainable policies and investments remains moderate. However,
reforms to be supported under the DPL are to a large extent well under implementation, also as
part of the EU accession negotiation process, which is expected to mitigate the risk of reversal or
delays. The recent unblocking of EU accession negotiations and a clear timetable for their
conclusion by mid-2010, provide a momentum for reform.
7. Poverty and Social Impacts and Environment Aspects
With economic activity projected to contract by around 5 percent in 2009 from 2.4 percent
growth rate in 2008, the fraction of the poor is expected to increase by some three percentage
points from the current 10 percent. A slowdown of the real sector has already worsened labor
market conditions with the newly registered unemployment showing a sharp increase by more
than 20 percent since December 2008. Job prospects have become meager as the number of job
vacancies fell by over 30 percent.
By simulating the impact of the crisis on those who were living below the income cutoff for the
poorest decile and quintile in 2008, based on data from the most recent household budget survey
(HBS 2008) and using a set of lead indicators about the dynamics of real incomes to allow
modeling the loss in earnings associated with the loss in employment (into unemployment, early
retirement or inactivity), the following conclusions have been made:

Only 0.8 percent of the combined impact is borne by the lowest income decile;

Only 3.1 percent of the combined impact is borne by the 20 percent of the poorest
population;

Policy measures considered under the DPL and their impact on the poor are mitigated by
a policy of waivers or exemptions for lower income households (in particular, the health
copayments are waived for adults earning less than HRK1,516 a month or belonging to
vulnerable categories like unemployed; old pensioners; students; people with disabilities,
high income threshold for applying a solidarity tax; or the provision of free-of charge
textbooks to beneficiaries of social welfare program and the survivors of war veterans).
Additionally, the social assistance reforms proposed under this operation are expected to mitigate
the impact on the most vulnerable. Some of these mitigation measures notwithstanding, the
Government should expect an increase in the number of unemployed or claimants for social
welfare benefits and services, as the crisis continued. The proposed reforms are expected to
protect the funding and facilitate the access to means-tested programs and unemployment
benefits.
The proposed support to budget and policy reforms has been screened against OP 8.6. The
proposed operation is likely to have positive effects on the environment, forests and natural resources.
8. Contact point
Contact: Sanja Madzarevic-Sujster
Title: Sr Country Economist
Tel: +385-1-2357 260
Fax: +385-1-2357 200
Email: [email protected]
Location: Zagreb, Croatia (IBRD)
9. For more information contact:
The InfoShop
The World Bank
1818 H Street, NW
Washington, D.C. 20433
Telephone: (202) 458-4500
Fax: (202) 522-1500
Email: [email protected]
Web: http://www.worldbank.org/infoshop