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Key Messages
The World Bank
EU10
Regular
Economic
Report

The prospects for growth of the EU10 countries and
Croatia as well as convergence with the EU15 are
likely to be uncertain over the next few years. Yet,
there are some initial signs in the US and EU markets
that the recession may be bottoming out. The rate of
contraction is expected to moderate from the second
quarter onwards, and growth could move into positive
territory in early 2010, as the slashing of inventory
and the forceful macroeconomic policy response in
the EU and other advanced economies lay the basis
for a recovery.

Countries that have weathered the initial crisis better
due to sounder economic fundamentals may still be at
risk from more protracted than anticipated recovery
of external environment. Although international
financial markets have stabilized and sovereign credit
default swaps (CDS) spreads eased substantially since
March, they are subject to high volatility mostly
related to slow recovery of the real sector and its
impact on financial sector stability.

Investors are still risk-averse. A mitigating factor for
the EU10 and Croatia is that a high proportion of their
debt is owed to foreign parent banks and companies
with strategic commitments to the region. This
suggests high rollover rates rather than a sudden stop
scenario. This was indeed the case so far for Croatia.

Still, the unsustainably high current account deficits
from the past are undergoing severe adjustments
across the region and Croatia. With the reduced
availability of capital inflows and rather slim
expectations of export growth recovery, adjustment
will have to happen at the expense of contraction of
domestic demand and overall output. The Croatian
GDP may well contract by 3-4 percent, depending on
the knock-on effect of the global crisis on the tourism
season.

Public consumption as well as wage restraint policies
remain key instruments for mitigating CAD
rebalancing risk in largely euroized economies like
Croatia. Flexibility in input markets will also help to
recover faster, which implies the need to accelerate
structural reforms during the challenging crisis
period, while ensuring effective functioning of social
safety net to absorb recession impact on the labor
market.
Croatia
Supplement
May 2009
External Environment
Economic stability in the region, as well as in the rest of the world, depends foremost on restoring
financial confidence. Greater international cooperation is essential for keeping capital linkages
open between the EU10 region and Croatia, and EU15 countries.
The prospects for growth and convergence of the region are likely to be uncertain over the
next few years. Rebuilding confidence in financial markets will take time, as well as the need to
bring down financial leverage which could curtail credit growth for businesses and households and
restrict external financing to the region. The vicious circle between deteriorating real economies
and worsening financial markets could result in a longer and more severe recession. Yet, there are
some initial signs that the recession may be bottoming out. The rate of contraction is expected to
moderate from the second quarter onwards, and growth could move into positive territory in early
2010, as the slashing of inventory and the forceful macroeconomic policy response in the EU and
other advanced economies lay the basis for a recovery.
The recovery from the global economic crisis depends foremost on restoring market confidence
with the help of a forceful and coordinated policy response. This includes providing financial
institutions with access to liquidity, dealing with toxic assets, and recapitalizing viable but weak
institutions. EU member states have provided about EUR270 billion for recapitalization of banks
and EUR3,200 billion for enhancing bank access to funding. All EU10 countries and Croatia have
established or expanded deposit insurance, and strengthened liquidity, mainly through expanding
repo operations (most countries), decreasing minimum required reserves (Bulgaria, Croatia,
Romania), increasing guaranteed amount of deposits with banks and providing foreign exchange
liquidity through swap arrangements or EU transfers (Hungary, Poland, Croatia). A number of
countries, including Hungary, Latvia, Poland, Romania and the Slovak Republic, have also
established recapitalization plans.
Figure [1]. Geographic Breakdown of Foreign Claims in the Banking Sector
Baltics
EU7 and Croatia
18.9%
24.2%
24.4%
Austria
Belgium
France
0.4%
4.8%
Germany
1.9%
Italy
8.9%
Netherlands
7.2%
Sw eden
66.5%
Other
19.1%
9.6%
14.0%
Note: EU7 refers to EU10 without the Baltic countries.
Sources: BIS, World Bank Staff calculations.
As financial markets calmed down, sovereign credit default swaps (CDS) spreads in EU10
countries have tightened substantially since early-March, even though they still remain far
above pre-crisis levels. Some countries in the region experienced a sharp widening in CDS spreads
by March on account of the well-publicized vulnerabilities in the banking sector or corrections in
sovereign ratings, like Latvia, Lithuania, Romania, and Hungary.
Output Developments
The economic outlook for the region and Croatia remains uncertain. Some countries may
experience a stabilization process that is more protracted than anticipated. Other countries that
have weathered the crisis better due to sound economic fundamentals may still be at risk from a
worsening external environment.
2
Figure [3]. Croatia : Industrial
(Index 2005 = 100, SA, 3MA)
Production,
120
Q4/08
Q3/08
Q2/08
Q1/08
Q4/07
Q3/07
Q2/07
Q1/07
Q4/06
Q3/06
Q2/06
Q1/06
Economic activity in Croatia slowed sharply in
Figure [2]. Croatia: GDP growth rates (in %) and
relative contribution of domestic and foreign
Q4 last year, but a large decline in imports
demand, in percentage points
enabled year-on-year GDP growth to remain
positive. This resulted in annual GDP growth
12
slowing to 2.4 percent in 2008. The main factor
9
behind the slowdown was weak personal
consumption, growing 0.8 percent in 2008 after
6
growth of 6.2 percent in 2007. Whilst personal
% 3
consumption was falling at the end of 2008,
0
government consumption recorded growth of 2.7
-3
percent in the last quarter of last year.
-6
Investment activity recorded an 8.2-percent
increase despite the significant slowdown
respective to previous quarters. Contrary from
Net foreign demand
Domestic demand
GDP
investments in fixed capital, adjustment in the
Source: CBS
level of inventories was quite rapid. The net
foreign demand contribution remained negative in 2008 –- although in Q4, a large drop in imports
far outstripped the deterioration in exports (3.6 percent vs. 1.7 percent) thus contributing
positively to the growth.
Figure [4]. Croatia: Retail Sales (Index 2005 = 100,
SA, 3MA) and VAT collection (HRK million, 3MA)
110
4.5
Retail sales (left axis)
Latest: Mar-09
Manufacturing
4.0
105
110
3.5
Total
100
3.0
100
95
2.5
VAT collection (right axis)
Latest: Dec-08
Latest observation: Mar-09
90
Jan-05
Jan-06
Jan-07
Jan-08
90
Jan-05
Jan-09
2.0
Jan-06
Jan-07
Jan-08
Jan-09
Source: CBS
Industrial production and retail trade volume have continued their steep downward trends.
Following a contraction of industrial production by 1.2 percent in the fourth quarter of 2008,
industrial activity declined by additional 10.9 percent in the first three months of this year.
Although production was affected by a disruption in gas supply and seasonal effects, the magnitude
of the fall and the fact that March was the fifth consecutive month when the industrial production
index recorded a year on year fall, indicates more severe problems. At the same time, labor
productivity in industry in Q1 2009 was down 3.4 percent y/y mainly due to a drop in processing
industry of 6.2 percent. Retail trade volume started to exhibit a decline since mid-2008, with a
sharp contraction of 16.9 percent observable in Q1 of 2009. The outlook for 2009 is subject to high
uncertainty, due to the importance of tourism in the economy and difficulty to gauge the likely
decline in tourism revenues. After the expected 5.8 percent y/y decline in Q1, in the optimistic
scenario, Croatia’s growth outlook is projected at -2.7 percent for 2009 with a slightly positive
growth in 2010. Given the uncertainties of tourism sector outcome, these projections are subject
to downside risk towards 3.5 percent decline in 2009.
Labor market and wage developments
A slowdown of the real sector has worsened labor market conditions. While firms were reluctant
to lay-off workers initially, the downward revision in the economic outlook is expected to reduce
3
employment significantly in 2009 and 2010 and increase unemployment beyond the current
adjustments on the flexible part (fixed-term contracts) of the market.
Jan-09
Jul-08
Jul-07
Jan-08
Jul-06
Jan-07
Jan-06
Jul-05
Jul-04
Jan-05
Jan-04
The slowdown of economic activity affected
Figure [5]. Croatia: Labor market developments,
labor market developments in the last
trend values
quarter of 2008 and early 2009. The number
of unemployed increased coupled with
80,000
340,000
employment reduction. The latest available
75,000
320,000
data on newly registered unemployment
300,000
70,000
showed a sharp increase by 35.2 percent y/y in
April 2009 thus contributing to the overall
280,000
65,000
number of unemployed which increased by a
260,000
UNEMPLOYED (left
60,000
significant 7.6 percent y/y –- the biggest
axis)
240,000
increase since 2001 –- to pre-2007 level.
RECIPIENTS OF
55,000
220,000
UNEMPLOYMENT
Although there was a slight nominal monthly
BENEFIT (right axis)
200,000
50,000
decline in unemployment due to seasonal
impact of April (Easter) on the back of the
service sector, the manufacturing industry saw
employment decline of 4 percent. The
Source: CEB
economic decline will likely lead to a shift of
formal to informal employment, thus negatively impacting tax collection.
Wage adjustments in the private sector have, to a larger extent, followed the pace of overall
economic contraction, which delayed stronger downside pressure on employment. The average
net wage growth in 2008 was 0.9 percent in real terms. Further signs of deceleration in business
sector wage growth were present at the end-2008 and beginning of 2009, particularly looking at
disaggregated data. Public sector wages increased in 2007 and 2008 due to a rise in the base salary
agreed between the Government and the trade unions of civil and public service employees for the
2007-2009 period. In April 2009, the Government renegotiated the agreement with the trade unions
rolling back the earlier given 6-percent salary increase.
Inflation and monetary policy
The slowdown in economic activity and subsequent decrease in the output gap have dampened
wage increases and reduced profit margins, which in turn have subdued inflation pressures. The
decline in inflation is set to continue during 2009, with the largest reduction expected in Bulgaria
and the Baltic countries. This trend is likely to bring down divergences in inflation rates across the
region. After years of high profitability, the soundness of the financial sector is being challenged
by the economic recession.
4
Q1 2008
Q3 2008
Q1 2008
Q3 2007
Q1 2007
Q3 2006
Q1 2006
Q3 2005
Q1 2005
Q3 2004
Q1 2004
Q3 2003
Q1 2003
Q3 2002
Q1 2002
Despite the increasingly likely deflation in
Figure [6]. Croatia: Quarterly CPI growth rate, y/y
the euro area, Croatia will not experience
these trends. Namely, at the beginning of the
8.0
year, prices were up due to the increase in
7.0
administratively regulated prices of public
6.0
health services and natural gas. The annual
5.0
inflation rate in the first four months stood at
4.0
3.9 percent, which is significantly lower than in
3.0
2.0
the same period last year. Beside seasonal
1.0
increase in prices of vegetables and fruits, the
negative impact on price stability came from
the depreciation pressures which boosted
prices of imported goods. The industrial PPI
inflation recorded a 0.8 percent of increase in
Sources: CNB, CROSTAT
the January-April period of 2009, which is
likely to impact stability of CPI in the rest of the year in case no further global commodity price
shocks occur. The inflation projection for 2009 remains at 3.5 percent.
Monetary developments in Q1 of 2009 were characterized by strong spillover effects of the
global financial crisis on domestic economy. The monetary policy framework has proven to be
robust enough to ensure financial system stability, thus justifying higher regulatory costs and
providing a significant buffer. Following the contraction of the reserve money in 2008, mostly due
to changes in the monetary policy framework, it rebounded strongly in early 2009. On the other
hand, M4 growth rate slowed to 3.3 percent y/y in March, mainly as a result of declining credit
activity and general weakening of economic activity. The more uncertain environment, limited
domestic and international financing sources will play an important role on the supply side.
Figure [7]. Croatia: Exchange rate pressures
110
Figure [8]. Croatia: International Reserves and
Banks' foreign exchange reserves, billion EUR
billion EUR
7.80
IREER (CPI) - left
105
16
7.70
14
7.60
12
7.50
10
7.40
8
HRK/EUR - right
100
95
90
Bank's FX reserves
CNB's international reserves
6
7.30
4
85
7.20
80
7.10
2
I 2003
IV
VII
X
I 2004
IV
VII
X
I 2005
IV
VII
X
I 2006
IV
VII
X
I 2007
IV
VII
X
I 2008
IV
VII
X
I 2009
1/03
5/03
9/03
1/04
5/04
9/04
1/05
5/05
9/05
1/06
5/06
9/06
1/07
5/07
9/07
1/08
5/08
9/08
1/09
0
Source: CNB
As a consequence of lower demand for loans as well as banks becoming more risk averse,
private sector credit grew by 9.3 percent by March 2009. Corrected for exchange rate
depreciation, of some 5 percent compared to end-2008, this suggests strong adjustments. Demand
for loans declined due to more stringent financing terms, while supply remained oriented towards
more secure financing of government borrowing requirements. The annual growth rate of
placements to enterprises began to decelerate as of end-2008 and stood at 11.9 percent in March.
The slowdown in bank lending was particularly evident in household loans. Their annual growth
rate went down from 12.1 percent in 2008 to 8.3 percent at end-March 2009. On the other hand,
banks’ placement to the central government grew by HRK 8.9bn in Q1 thus reaching HRK 30bn,
which is almost double compared to the same month last year.
Official FX reserves are still at adequate levels, although declining. The foreign reserves of the
central bank declined by 9.9 percent y/y to EUR 8.9bn at end-March, following an 11.6 percent y/y
decline a month ago. As for commercial banks, their foreign reserves were down by 23 percent y/y
to EUR 3bn, mainly due to the changes in monetary framework. Deposits denominated in foreign
currency account for 63.7 percent of total deposits, almost equal to the ratio of foreign currency
and foreign currency denominated loans to overall loans (68.3 percent). Over the last few months
the ratios are increasing with some of local banks completely abolishing loans denominated in local
currency. This is most noticeable in the loans granted to enterprises.
With significant private sector balance sheet vulnerabilities, exchange rate stability is
important for households but also unhedged corporates, and indirectly also for the quality of the
portfolio of financial institutions. With gross reserves covering around 63 percent of strongly
increasing short-term debt, Croatia will be well advised to build flexibility elsewhere through, in
particular, swift progress with structural reforms, adequate external financing, and appropriate
fiscal response.
Public finance
The EU10 countries and Croatia face the difficult task of reconciling short-term fiscal needs with
ensuring longer-term fiscal sustainability. For the recovery, it is important to protect priority
5
programs to enhance growth prospects while safeguarding medium-term fiscal consolidation by
reducing fiscal deficits and bringing public debt to a sustainable trajectory.
The 2008 outturn was marked by strong revenue growth, which allowed for additional spending
as well as marginal reduction of fiscal deficit including off-budget and quasi-fiscal activities.
The latest MoF data show that the consolidated general government (CGG) revenues rose by 6.4
percent y/y in 2008. This rise resulted primarily from the strong growth of VAT revenues (which
grew by 9.4 percent y/y), followed by revenues from social contributions and corporate income tax
revenues. Total CGG expenditures (GFS 1986) went up by 5.4 percent, mostly due to wage growth
and social benefits. Below the line, the deficit was financed mostly by domestic borrowing and
privatization receipts which amounted to 4 percent of GDP. Public debt, including state guarantees
and the debt of HBOR, increased by 2.2 percentage points of GDP in 2008, to 42.3 percent of GDP.
The 2009 budget revision reduced expenditures by 1.6 percentage points of GDP. However, due
to lower than planned revenues (of
Table [1]. Croatia: Public Finance (GFS 1986)
some 2.3 percent of GDP) the CGG
2008
2009
deficit increased to 1.6 percent of
in % of GDP in % of GDP
GDP (from 0.8 percent according to
1. General Government Balance
-2.6
-2.7
the ESA95 methodology) or to 2.7
State Budget
-1.1
-1.7
percent
of
GDP
(GFS
1986
Extrabudgetary funds
-0.3
-0.2
methodology). Over one quarter of the
HAC
-0.9
-0.5
Local Government
-0.3
-0.3
expenditure adjustment will come
2.
General
Government
Balance
Financing
(3+4)
2.6
2.7
from the reduction of salaries of civil
3.
Central
Government
Balance
Financing
2.3
2.4
and public servants, followed by
3.1.
Capital
revenues
and
privatization
0.4
0.3
subsidies’ and investments’ reduction.
3.2. Foreign borrowing
0.1
0.5
Further budget cuts might become
Drawings
1.2
3.0
necessary depending on the size of
Repayments
1.1
2.5
3.3. Domestic borrowing
2.4
tourism revenues and the availability
1.9
Drawings
3.6
2.8
of external financing. Government is
Repayments
1.2
0.9
currently
preparing
a
euro3.4. Deposit change
0.6
0.3
denominated bond offering (EUR
- State Budget
0.5
0.1
750mn), a first since 2004, which
- Extrabudgetary funds
0.2
0.3
- HAC
-0.1
should help refinance large amounts
0.3
0.3
4. Local Government Financing
of maturities coming due in the near
Memo:
-0.2
Pensioners' Debt repayment
-0.3
future. However, regardless of its
HBOR
-0.7
-0.6
outcome,
further
expenditure
Shipyard Guarantee call
-0.4
#DIV/0!
adjustments may be advisable to
BROADER MEASURE OF FISCAL BALANCE
-3.6
-3.8
mitigate the impact of the automatic
Sources: MoF, IMF, staff calculation and estimate
stabilizers, activated during late 2008
and early 2009 with the recessionary economic trends, potential further revenue shortfall as
employment and wages further decline, and uncertainties regarding shipyards’ debt service due to
delayed restructuring and privatization.
External vulnerability
Croatia's external deficit in 2008 amounted to EUR 4.45bn, rising 37.6 percent y/y. The rise in
the deficit is ascribed to the deteriorating foreign trade in goods, and moderate outcome in the
exchange of services. The trade deficit exceeded EUR10.8 billion, an increase of 15.2 percent y/y.
On the other hand, the services account surplus amounted to EUR 7bn, up 11.1 percent y/y. On the
financing account, net FDI inflows recorded a decline of 19.3 percent, despite a robust inflow
related to MOL’s acquisition of an additional stake in INA. Thus, FDI C/A deficit coverage declined
from 107.6 percent in 2007 to 63.1 percent in 2008. Portfolio investments were negative, mainly as
a result of asset purchases, while other investments were more than doubled, showing the
expected pressures on debt-creating financing.
External adjustments are underway with foreign goods trade on downward trajectory. March
goods trade gap fell by 20 percent y/y to EUR 0.8bn largely thanks to a 15-percent y/y slump in
6
imports (mostly capital and intermediate imports). The Q1 deficit thus fell to EUR 1.8bn (-32
percent y/y) and yielded an export to import cover of 51 percent. Within processing industry the
highest contribution to the negative exports growth had manufacture of wood and wood products
except furniture; and coke and refined petroleum products. Imports were mainly driven by capital
goods and oil, which registered a drop of 24.6 percent y/y. With services income subject to high
uncertainty, CAD could be in the range of 6.5 to 7.0 percent of GDP in 2009.
Figure [9]. Croatia: External imbalance worsened
in 2008
8
6
4
2
0
% -2
-4
-6
-8
-10
-12
Figure [10]. Croatia: FDI structure, 2008
7.0
6.4
5.7
4.4
28.5%
3.2
2.0
6.7%
4.4%
4.5%
-0.1
-0.6
-3.2
-4.4
-7.5
-6.3
4.2%
-5.5
-6.9
37.8%
Financial intermediation, except insurance and pension funds
Manufacture of coke, refined petroleum products
Real estate activities
Extraction of crude petroleum and natural gas
Retail trade, except of motor vehicles
Hotels and restaurants
Other
-9.4
2001
2002
2003
CAB
2004
2005
2006
13.9%
-7.6
2007
2008
Non-debt creating inflows
Sources: CNB, CROSTAT
Croatia’s gross external debt went up by EUR 6.4bn (19.3 percent) in 2008, reaching a total of
EUR 39.3bn (83 percent of GDP) at end-2008. The growth was mostly the consequence of strong
corporate foreign borrowing. The latter, however, slowed down noticeably towards the end of the
year. In contrast to this, after decreasing their debt in the first nine months of 2008, the
government sector and banks increased their foreign liabilities in Q4 of 2008 relative to the end of
the previous year. The gross foreign debt of the country increased further to EUR 39.9bn at endJanuary by 1.6 percent m/m on the back of stronger banking sector borrowing which rose by 3.7
percent m/m to EUR 10.4bn at end-January.
The average maturity of that debt is also shortening: in 2009 alone, projected debt service
amounts to 30 percent of GDP, a steep rise from single a digit requirement in 2008. As noted
above, strong efforts have begun to mobilize the necessary funding, in the face of the tight
financial conditions, a scarcity and cost of external financing.
7