IMF Concludes 2009 Article IV Consultation With The Republic Of Croatia

by Mike Godfrey, Tax-News.com, Washington

23 June 2009

The IMF has concluded an Article IV consultation with the Republic of Croatia. A robust policy response has helped Croatia to maintain market confidence and navigate the crisis relatively well, but downside risks remain significant. While the external imbalances are receding from the previous high levels, the adverse economic and financial conditions feed on each other, amplifying the downturn, reducing access to much needed external financing to cover sizeable external liabilities maturing in 2009–2011, the IMF reports.

The Central Bank of Croatia (CNB) has taken a number of measures to maintain the orderly functioning of markets, avert destabilizing pressures on the kuna, and help address the fallout of the crisis on the financial system. Croatia's exchange rate strategy limits policy options to cushion the downturn, and, according to the IMF, a cautionary monetary policy will need to be continued until external pressures abate. The CNB maintained close cooperation with foreign banks to secure adequate external funding and reduce banks’ liquidity risk, and it strengthened the oversight and monitoring of the banking system and upgraded stress test exercises, reports the IMF.

The IMF states that fiscal policy has been under pressure. Revenues, especially VAT and excise taxes, started to underperform in late 2008, reflecting sharply lower trade volumes and declining economic activity. In response, the government reduced cash spending on goods and services, limiting the 2008 general government deficit to 0.9% of GDP. Based on a wide range of spending cuts, including a freeze of salaries, the revised budget for 2009 aims for a deficit of 1.6% of GDP, entailing a cyclical tightening. However the IMF consider that the fiscal deficit is likely to widen to above 2% in 2009, due to a further deterioration of macroeconomic conditions. The government’s domestic borrowing has recently risen sharply, with the government increasingly competing for resources with the private sector in the current tight credit environment. The recent successful eurobond issue signals investor confidence in Croatia and helps reduce the government’s domestic financing needs, according to the IMF.

The IMF Directors made the following recommendations:

Croatia should undertake 'a diagnostic review of the financial conditions of all banks, and require those with potential recapitalization needs to raise capital buffers'. The framework for resolution of troubled assets could also be upgraded, including through a swift adoption of the new foreclosure law, advise the IMF. While many elements of Croatia’s contingency framework to deal with banks in distress are consistent with international best practice, the IMF considered that there was scope for improving interagency coordination on crisis preparedness and management.

In view of the downside risks to revenue collection, the IMF thought spending commitments should be reined in. A strategy should be developed to contain a possible decline in taxpayers’ compliance and to avoid further public sector arrears, the IMF warned. Public spending must be rationalized without unduly compromising the delivery of public services, belives the IMF. Efforts should be stepped up to modernize the civil service, improve cost recovery for social services, reduce subsidies, and target social spending better, the IMF opined.

The IMF thought resources should be reoriented towards the tradable sector in order to boost growth and raise productivity and the business environment should be improved further by promoting labour market flexibility. The restructuring and privatization of loss-making state-owned enterprises should be completed swiftly, the IMF concluded.

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