Croatia's economy will grow 2.4% this year and average inflation will be 7.5%, the International Monetary Fund said in a press release on Thursday, adding that the near-term fiscal policy should support a tightening of the monetary policy and avoid adding to aggregate demand.

The IMF revised upward its earlier forecasts, given that in a press release by its Mission at the end of a visit as part of regular consultations with member states on 23 May, it projected this year’s economic growth at 2.2%, while in April it forecast a growth of 1.7%.

The IMF Executive Board concluded the Article IV consultation with Croatia without convening formal discussions, the press release said.

The Board notes that on 1 January, Croatia became the 20th member of the eurozone, a testament to the significant progress achieved since joining the European Union in 2013. The euro adoption has improved sovereign ratings, eased access to capital markets, and significantly reduced exchange rate risks.

Economic growth in 2022 expanded by 6.2%, the press release said, driven by domestic demand and tourism. The fiscal position improved considerably to a small surplus and the public debt declined significantly to about 69% of GDP, below pre-pandemic levels. However, surging energy and food prices drove headline inflation to a multi-decade high at year end.

Economic growth is expected to moderate to 2.4% in 2023 due to weak external demand, tightening financial conditions, and still high global uncertainty. Growth is projected to gradually recover from 2024 towards its potential.

Inflation is projected to recede to an average of 7.5% in 2023 and fall towards the European Central Bank’s 2% target in late 2025, the press release said, adding that the adoption of euro has had a very limited impact on inflation.

The outlook remains subject to significant uncertainty, but risks to growth are broadly balanced. Downside risks include intensification of Russia’s war in Ukraine, a renewed surge of commodity prices and inflation, a sharper global or regional recession, and tighter-than-expected financial conditions. On the upside, the euro adoption and entry into the Schengen area could provide a stronger boost to tourism, trade, and investment. Risks to inflation are tilted to the upside, the press release said.

The near-term fiscal policy needs to complement monetary tightening and avoid adding to aggregate demand. The labor market is tight, core inflation remains elevated, and the euro adoption has mitigated the impact of ECB’s tightening. Therefore, an expansionary fiscal stance risks fueling domestic demand and inflation and hurting Croatia’s competitiveness. Broad-based support measures, notably energy price caps and tax cuts, need to be reversed.

Maintaining a growth-friendly fiscal consolidation over the medium-term is paramount, by improving tax policy, reducing spending rigidity, and enhancing spending efficiency.

Given Croatia’s high budget spending rigidity and the need to further reduce public debt, any tax reforms should preserve revenue resources while improving the tax system structure to reduce distortions and support fairness and growth.

Modernizing the property tax and reducing favorable taxation on short-term rental income would help dampen housing demand, boost supply, and encourage labor participation. A simplified and transparent public sector pay system that rewards merit and productivity would enhance public services and make the sector more efficient.

Worsening healthcare and pension costs due to an aging population call for renewed efforts to lengthen the working life and decisively address healthcare arrears.

Enhancing the monitoring and corporate governance of state-owned enterprises will reduce potential fiscal risks and maximize their contribution to growth. Efforts to strengthen the public investment management system, including establishing a strong central coordination function in the Ministry of Finance, should continue.

The financial system is currently stable, but continued vigilance is needed given ongoing challenges.

Advancing structural reforms is key to reap the full benefits of euro adoption and sustaining income convergence. The authorities should continue their commendable and steadfast implementation of the National Recovery and Resilience Plan. Raising productivity, advancing the green and digital transition, and making the best of an aging and declining population are priorities.

The currently tight labor market offers an opportunity to carry out further labor market reforms. More ambitious reforms, along with the EU funds, are warranted to address relatively low firm-level productivity and inefficient resource allocation, the press release said.