Sanja Madzarevic Sujster: Every arrangement with the IMF strengthened Croatia

January 20, 2014

Sanja Madzarevic Sujster, The World Bank Senior Country Economist for Croatia Globus Weekly

2014 is believed to be the last opportunity for Zoran Milanovic’s government to tackle structural reforms and start changing Croatia’s prospects. After two years of wondering, reform reversals and compromises the ruling coalition has no right to fail. 2015 is already an election year which means that significant changes will not be expected.

The World Bank Senior Country Economist for Croatia, Sanja Madzarevic Sujster, in an interview for Globus, reveals concrete threats facing Croatia this year.

The World Bank expects an increase in borrowing costs in 2014. Given the Croatian credit rating and the 2014 budget according to which the government plans to borrow HRK40.6 billion, what would the increase in the cost of borrowing mean for Croatia?

A: Despite the growth recovery expected globally and in the region, the unfinished debt crisis resolution in the Eurozone as well the tapering on the US market would continue to differentiate emerging market investments as well as lead to a further rise in global interest rates. This may mean lower capital inflow or higher interest rate for emerging markets, in particular for sovereigns with high risk. Croatia already pays some 150-200 basis points higher interest rates compared to its Central European peers, as the country lost its investment credit rating. In 2013, more than 3 percent of GDP will be paid for the interest payments on public debt. Further rise in interest payments as well as in public debt would render public finances highly unsustainable.

Can we already speculate about interest rate Croatia could be charged on bonds next year, if we know that the November borrowing in the US market of $1.75 billion came with an interest rate of 6.2 percent.

A: No, we cannot. It would depend on many factors, including the growth prospects of the economy, sustainability of public finances under the Excessive Deficit Procedure, as well as external developments.

Is such an interest rate adequate for Croatia and what are the alternatives?

A: Such an interest rate is some 2.5 percentage points higher than Croatia’s potential growth rate, and therefore is unsustainable. It means that we are unable to generate enough revenues to cover the interest payments, not to mention the principal repayment. The alternative is restoring sustainability of public finances through generation of primary surpluses, where non-interest spending is lower than revenues. This implies a reduction in public debt over time.

Does that increase in the cost of borrowing means a rise in interests on other loans? Is it possible to estimate the interest rate public sector would pay next year?

A: The global rise in interest will of course impact private sector as well. Public enterprises will be affected, too.

What do you think about the potential arrangement with the IMF?

A: The IMF arrangements are useful in countries that are facing high debt service costs and need to restore credibility of their macroeconomic policies. In many countries in our region, the Fund program helped reduce the borrowing costs, introduced the diligence in implementing credible policies, and has kept the policy makers focused on critical policy issues within a pre-defined timetable. Croatia had several programs with the IMF in the past and had grown stronger in economic terms thereafter.

What do you think about the idea of ‘national’ bonds?

A: I am not sure what a demand for that would be among citizens. The country has a historically high unemployment rate of over 21 percent and has experienced a decline in real wages for the last several years. Additionally, half of the working population struggles with the repayment of its loans. With the well-developed financial intermediation and the excess liquidity in the banking sector, I am not sure that even authorities are thinking about it.

For 2014 the World Bank forecasts GDP growth based on the announced private sector investments. Aren’t you afraid that this growth could be stifled by consumption decline affected by the excessive deficit procedure?

A: We have taken the consumption decline into account when forecasting growth for 2014. As expected, the EDP proposed for Croatia has been less demanding than feared by some analysts. It gave Croatia three instead of two years to bring its finances to a more sustainable level. The downside risk, however, lies with the announced private investments. Any delay in reforms or change in economic/political stability may lead to rethinking Croatia as a favorable investment destination for both domestic and foreign investors. Therefore, it is important to hold the course right and continue even more rigorously with the announced reforms.

Early last year, you projected a 0.8 percent growth for 2013. Why do you think this did not happen?

A: We have revised our spring 2012 growth projections already in autumn 2012 to negative for 2013. A double-dip recession in Eurozone was evident in mid-2012. At that time a fragile recovery of Croatia’s economy came again under the negative external pressure. In anticipation of the July 2013 CEFTA exit, some domestic companies have also transferred their production facilities to the neighboring countries, which has deepened the 2013 recession from the earlier anticipated 0.4 percent to 0.8 percent.

Can you give a brief comparison with EU countries according to the most important macroeconomic indicators (GDP, unemployment, exports/imports, deficit, tax pressures) and say where we are today compared to them?

A: During the ongoing five-year recession Croatia has lost more than 11 percent of its pre-crisis output. This has been one of the deepest declines among European economies. Croatia has gone backwards in terms of its convergence with the EU living standard. At the same time, the rest of the Central European countries have been able to restore the convergence path. The unemployment rate at close to 16 percent at the internationally-recognized methodology is one of the highest in Europe. The most worrying is the unemployment rate among youth and of those who are long-term unemployed. Close to 60 percent of the unemployed are long-term unemployed which leads to social exclusion problems. The employment rate for the population aged 20–64 is currently below 56 percent; whereby the EU2020 strategy target rate is 75 percent. This huge gap suggests underutilization of labor in Croatia. Public debt and deficit is close to the average of the EU group; however, the trend of public debt growth is worrisome, along with the inability to tame excessive deficit for the last five years.

There is a great debate about tax pressure in Croatia. How do you define tax pressure and how big a problem this is in Croatia?

A: With a tax burden of about 38 percent of GDP and limited competitiveness, there is not much fiscal space for raising the tax rates. Croatia has the second highest total tax burden in EU, and only one of the EU27 countries has higher indirect taxes. Restrained export growth and performance demonstrate its competitiveness problems. In recent decades its penetration of EU markets has been among the lowest in emerging Europe. This suggests that there is minimal space for tax rate increases—which in any case would further erode competitiveness. In fact, both business and government can benefit from tax systems that are simple to administer and that promote compliance. An alternative would be to build up the audit capacity of the Croatian Tax Administration (CTA) in terms of risk assessment techniques, audit methods, and employee skills and training, and to focus more tightly on large taxpayers. Additionally, there may be a scope for introducing modern taxation of property and further rationalizing quasi-fiscal fees, which the government has already announced and have been working to that extent.

You said that Croatia currently does not need any more new taxes, but once technical requirements are met, it should introduce a property tax. What effect would such a tax have on Croatia? What do you think of the arguments of a part of the current government that such a tax should not pass until the economy recovers?

A: Croatia has one of the highest VAT rates in Europe, which has been rising in many countries as part of the global move to tax consumption more heavily and income more lightly. However, fiscal space for raising VAT rates further is narrowing. International experience also warns against raising payroll taxes that would suppress both employment and labor-intensive growth. Introducing a modern value-based property tax and further rationalizing quasi-fiscal fees would help with revenue generation, but revenue potential is likely to be very low through the medium term. In OECD countries the property tax represents 2 percent of GDP; in developing countries it averages 0.3–0.7 percent, while Croatia currently collects around 0.3 percent of the GDP in tax on real estate transactions, tax on the secondary property and communal contribution. The property tax base in Croatia is deeply eroded by a combination of legal exemptions, undervaluation, low collection rate and failure to cover all properties. Tapping the property tax revenue potential would require stronger local governments and comprehensive reform consisting of three critical steps: (i) identify the properties being taxed; (ii) assess the property value and the tax base; and (iii) set the tax rates accordingly. The technical requirement is up-to-date land and cadastral registry.

There's a great debate about the possibility of the present Government of Croatia to carry the economy out of the crisis. When you look at the last two years, could Croatia today have a positive GDP growth if the reforms had been made in the first year of its mandate or the Government’s argument is right when saying that the private sector failed and caused a deepening of the crisis?

A: Croatia is indeed going through a very difficult period and all segments of society have been affected. The government is facing a very challenging task of having to tame public debt growth and reduce public consumption while at the same time trying to protect the vulnerable. This is never easy, especially as results of reforms and the benefits are not seen and felt overnight but take several years to have full effect. At the same time, the corporate sector has been hit by the long-delayed restructuring and had to delay any investment plans. Sustaining and pushing forward with the reform efforts to restore macro stability, but equally important to create a positive investment climate for both foreign and domestic investors, so that people of Croatia can feel the benefits as soon as possible, is a priority.

Recently, in an interesting article the Serbian Minister of Economy mentioned that in Serbia anticipation of foreign investors as rescuers took on myth dimensions. He argues that waiting for foreign investment today is only used as an excuse by the government that does not want to change anything. Finally, he concludes that the state actually should focus on relieving the local economy and creating a good business climate. Do you agree with that when it comes to Croatia?

A: Private investments will come if you have created a climate that nurtures such investment opportunities and guarantees that after the investment period a company will be able to generate profits. A combination of actions that deal with the investment climate, investment facilitation services, privatization of locked state-owned assets in unprofitable companies, as well as restored macro stability to reduce the sovereign risk premium is what the government is proposing for years ahead. We would suggest the same. Many of the actions taken in 2013 have been following that direction and some early wins are already visible.

How much Croatia has lost due to the CEFTA exit? In the first two months of EU membership exports fell by 11 percent.

A: Following the Croatia's accession to the EU, the new trade regime between the CEFTA countries and Croatia introduced an asymmetric trade liberalization regime. That means that the countries in the region retained the custom-free export preferences to the Croatian market as regulated under the EU Stabilization and Association Agreements; however, Croatian export is charged with tariffs applied to the EU products. Current Croatia’s exports to CEFTA countries comprise 20 percent of total Croatian exports. In 2012, Croatia exported products worth EUR1.7 billion, twice as much as was imported from CEFTA to Croatia. The Croatian National Bank has estimated a loss of 0.2-0.3 percent of GDP in 2013 due to the CEFTA exit.

Of course, that by this trade regime Croatian companies have lost some competitive edge -- the most affected being tobacco and agricultural products. The EC has launched a discussion with the CEFTA members on the Article 7 in the CEFTA Stabilization and Association Agreement, which implies mitigation of prescribed conditions and a reduction of high rates. However, it may take time for Croatia to restore trade flows affected by the exit from the CEFTA area, if at all. Large local companies that had been present at the CEFTA market, in particular in food industry, have transferred part of their production to the neighboring countries to mitigate the tariff barriers. Out of EUR1.4 bill of all Croatian outwards investments into the region since 1993, almost one-fifth were concluded in 2012 ahead of the Croatian accession to the EU, mostly in Serbia and BiH. Serbia per se has seen more than one quarter of all investments by Croatian firms concluded in 2012. 

Do you think that the Excessive Deficit Procedure could be a second chance for Croatia? Which are at present the most urgent and most needed structural reforms for Croatia?

A: The EDP is absolutely a good disciplinary instrument for restoring macro stability and reducing macro imbalances. In a way, the EDP provides a certain stability anchor. Without addressing macroeconomic weaknesses through sustained fiscal adjustment and institutional reforms, Croatia will not be able to benefit fully from the EU membership, and the quest for future prosperity may prove elusive. Without adjustment, the high deficit and public debt would signal the inability to join the Eurozone at the foreseeable future. Similarly, without creating the fiscal space of around 0.5 percent of GDP per year for the absorption of EU funds, Croatia will lose the opportunity to fund productive investments into innovation, education, and infrastructure through grant funding and support its convergence process. Taken together, these risks are substantial. Fiscal consolidation effort that is expenditure-based is thus the priority. Social sector reforms as well as public administration reform are thus priorities.

Similarly, without accelerating structural reforms in the real sector, especially in the area of labor market, investment climate, and public sector efficiency, this will further stifle competitiveness and any prospects for recovery of growth and jobs. Croatia’s labor markets are among the most rigid in the EU and this is a large part of the reason behind high and chronic unemployment. Paradoxically, for a country that achieved so much and entered the EU, Doing Business indicators rank Croatia similar to Albania, Moldova, and Serbia.

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