Although Croatia's government utilised the country's recent economic upturn to reduce debt and strengthen external buffers, important challenges still remain, such as the need to restructure public administration and make the pension and health care systems sustainable, a delegation of the International Monetary Fund (IMF) said on Monday.

Although Croatia’s government utilised the country’s recent economic upturn to reduce debt and strengthen external buffers, important challenges still remain, such as the need to restructure public administration and make the pension and health care systems sustainable, a delegation of the International Monetary Fund (IMF) said on Monday.

An IMF mission was recently on a visit to Croatia as part of their regular advisory visits. Their report on Croatia’s economy was published by the IMF and the central bank on Monday.

The IMF noted that relatively low levels of public and private investments, and the emigration of young people hamper the nation’s medium-term growth prospects.

“Emigration and population aging are generating labor 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 said, adding that “a sizable restructuring of public administration” was essential.

Other important issues to tackle are fixing the health care and pension systems, the IMF said, noting that although some progress has been made on those fronts, the momentum needs to be sustained.

“Acting decisively now – under favorable conditions – would ensure higher living standards in the future,” the IMF delegation said.

Transforming to a more dynamic economy is needed

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,” IMF said.

Further integration with Europe through entry into the ERM II monetary system and the banking union will set the stage for the adoption of the euro. But to enjoy the full benefits of the EU currency union, deeper structural changes are essential, as well as the continued careful management of the country’s public finances.

“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,” IMF said.

Spending on public sector employees remains among highest in region

Compared with regional peers, Croatia currently has one of the largest spending for public employment, measured in proportion of the size of its economy. Furthermore, many municipalities do not have sizable populations, raising the need to merge services which would result in improved efficiency of local government.

“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,” IMF said.

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.”

The further easing of administrative, tax, and para-fiscal fees, will also produce collateral benefits by improving the business climate, enabling higher private investment, and more job creation, the IMF said.

Pension reform essential

The recently passed pension reform is an important step in putting the system more in tune with the reality of increasing lifespans, and to make it more sustainable and equitable across generations.

“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 IMF said in its statement.

Employment has picked up notably over the last two years, and the challenge now is to sustain this expansion. Yet, the labor 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,” IMF said.

Labor 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,” IMF said.

Solutions that better balance the considerations of both employers and employees are needed, and 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 said.

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 labor force participation.

Introducing property tax should be reconsidered

Commenting on Croatia’s fiscal policy, the IMF said that recent budget performance has been solid.

The first ever budget surplus since independence was achieved in 2017. A small surplus might also materialise in 2018, depending on the size of one-off expenditures related to shipyard guarantees.

IMF said that its fiscal recommendations are motivated by two important medium-term goals – creating space for fiscal policy manoeuvres that could be used in the event another recession hits the economy, and also to improve Croatia’s medium-term growth prospects.

“To achieve this, 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 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,” IMF said.

In terms of spending, the increase in funds for public investment, the reduction of expenditure on public employment, as well as reforming the social benefits system to better target the most vulnerable groups in the society, are the three top priorities. On the revenue side of the budget, recent gains need to be preserved.

“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 fair, 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 modernisation of the land registry and the cadaster,” IMF said.

More efficient health spending required

Regarding the health sector, the IMF said that health spending needs to be made more efficient, and that administrative costs should be reduced. 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 health care system, and the reduction in the numbers of non-paying participants for supplementary benefits, although some of this came as a result of increased emigration.

“Still, a more comprehensive transformation requires a more rational premium and co-payment structure, ensuring that exceptions are minimised to protect only the most vulnerable,” IMF said.

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,” IMF said.

Banking system stable and profitable

The IMF delegation concluded its report by noting that the central bank continued to deftly navigate the environment of low interest rates and ample liquidity.

“Going forward, the central bank will need to pursue policies, which will allow the economy to accommodate potentially tighter external conditions and harness inflation expectations,” IMF said.

The banking system is, on average, very liquid, well capitalised and profitable. The non-performing loan ratio is declining, in part due to their sales to third parties.

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 said.

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