Soon a new center-left government will take the helm in Croatia, following national elections that brought victory to the opposition parties. Barring any last minute surprises, Croatia’s new premier will be Ivica Racan. Racan was leader of the Social Democratic Party (the old Communist Party) that lost the elections in 1990, and then embraced social democratic values. Together with the Social Liberals the new leadership plans to lead Croatia in a new direction—embracing the market economy, bringing the country closer to the European Union, boosting employment, and improving living standards. But first the burdensome legacy of the last decade will need to be cast off.

The Wrong Choice

At the start of the transition some 10 years ago, socialist countries had a choice among several macroeconomic policies, including shock therapy and gradual stabilization. Croatia chose shock therapy. As it turns out, this was the wrong choice. Shock therapy for Croatia did not mean "recession today for the sake of growth tomorrow"; it meant "recession today for the sake of recession tomorrow."

In October 1993 Croatia launched a stabilization program with the primary goal of defeating inflation. This program was based on applying a nominal exchange rate anchor—Croatia’s currency, the kuna, was linked to the deutschemark—and wage, price, and interest rate anchors. By January 1994 Croatia’s annual inflation rate dropped while the kuna appreciated. In 1995 GDP growth reached 6.8 percent, a rate that continued until 1998. During this period, the annual inflation rate stabilized around 3 percent.

Adverse consequences of the stabilization program soon surfaced, however. Unemployment rose gradually until it reached the present level of 20 percent. Output decline since 1990 has been only partially responsible for this high jobless rate. A more important factor has been the privatization of state enterprises. Not that these enterprises became streamlined and laid off excess workers; rather, the new owners were generally more interested in stripping assets and making quick profits than in engaging in long-term business development. The result has been massive layoffs.

The balance of payments deteriorated, in part as a result of the worsening trade balance. Croatian enterprises could not make up for huge export losses suffered in the early 1990s. Appreciation of the kuna undermined the competitive position of Croatian exporters. Foreign sales have been on the decline since 1994, with exports dropping 10 percent in 1999, despite the weakening of the kuna since the end of 1998. The Kosovo war also set back tourism—a major currency earner for Croatia.

National savings gradually shrank, and net investments declined. Introduction of the value-added tax in 1998 brought temporary respite, but the tax burden remained excessively high. The heavy tax burden on enterprises leaves no room for private or public investment. The outcome has been declining output and increasing indebtedness. To maintain the value of the kuna, the National Bank stuck to its restrictive monetary policy, keeping real interest rates high. Domestic and foreign debt reached 51 percent of GDP.

Burden of Bad Loans

Because many laws and regulations were not implemented or enforced, a culture of nonpayment prevailed in Croatia. Insolvency of the state spread to enterprises. By 1999 total arrears reached $3 billion. With many borrowers unable to repay debts in time, the volume of bad loans increased. Fiscal discipline was abandoned. Banks, already struggling with bad debt, were forced to aid enterprises. Bad debts reached 11.1 percent of banks’ total assets in 1997. In 1999 nine banks, with 8 percent of Croatia’s total bank assets, declared bankruptcy. Public investments, after dropping 7.5 percent between 1995 and 1997, were cut another 25 percent in 1999.

Enterprises complained that policies changed frequently, unexpectedly, and sometimes even retroactively. They also complained that uncertainty surrounded official announcements, information was scarce, the business community was excluded from the drafting of rules and regulations affecting business decisions, property rights were uncertain, payments for sales or services were often denied, theft and crime were pervasive, and the judicial system was unreliable.

Economists expect the slowdown of the Croatian economy to continue in 2000, with growth rate estimates ranging from 0.9 percent to a decline of 2.5 percent, similar to the trend in 1999. The $9.2 billion foreign debt will likely increase. Payments of the loans’ principal due in 2000 will consume 5 percent of GDP. The exchange rate, now at 7.5 kuna to the dollar, may depreciate further in 2000. Many economists predict that the balance of payments will worsen, foreign exchange reserves may decrease, and, as a result of contraction in the money supply, interest rates may increase in the coming year.

Entering a New Course

More bank failures and higher unemployment, at least in short term, are predicted for the Croatian economy. Cuts in state expenditures, which have reached 75 to 80 percent of GDP, could aggravate already serious social conditions, and the 25 percent poverty rate—mainly among pensioners—is likely to rise further.

The expectation that a stabilization program without consistent structural reforms could lead to economic revival and successful transition to a market economy proved wrong. As long as Croatia postponed consistent structural reforms it also postponed economic growth. In a macroeconomic environment that neglected the growth-driven sectors and discouraged investments and savings, recession was all but inevitable. With the new course being set for Croatia’s economic policy, this chain seems at last to be broken.