Republic of Croatia : Staff Report for the 2015 Article IV Consultation

KEY ISSUES Removing structural obstacles to growth. After six years of persistent contraction, Croatia’s economy is showing signs of a tentative recovery, supported by a favorable environment—the last economy in emerging Europe to exit the post-Lehman recession of 2008/09. Deep-seated structural factors have impeded the economy’s capacity to adjust, many of them relating to incomplete transition of Croatia’s corporate sector toward market orientation. While the authorities have made progress with some structural reforms in previous years, others remain incomplete—notably reform of the bloated, inefficient state- owned enterprise sector and of Croatia’s opaque governance system, characterized by much overlap between different layers of government. Unless addressed, these factors are bound to weigh on activity going forward. Restoring Fiscal Sustainability. Large fiscal vulnerabilities have built up in the wake of the recession. In the face of high fiscal deficits and public debt, policy has started to move in the right direction under the auspices of the European Commission’s Excessive Deficit Procedure. However, it requires more of a long-term orientation: a comprehensive consolidation plan should aim not only at reducing the deficit, but also at restructuring the budget to render it more growth and employment friendly. Safeguarding Monetary and Financial Stability. The kuna-euro exchange rate anchor remains without viable alternative for the time being, given the high degree of loan euroization. The banking system has remained resilient despite the drawn-out recession. Continued supervisory vigilance is needed to preserve this record. Previous Staff Advice. No major additional progress has been made on structural reforms since the 2014 Article IV consultation. Fiscal consolidation has advanced gradually, although efforts to reduce the headline deficit have been frustrated by revenue underperformance in a deflationary environment