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The Croatian Pension System is Fiscally Exhausted and Creates Inequalities

January 20, 2015

Carlos Pinerua Jutarnji list

If one is to judge by economic forecasts, this will be another year of downturn, the seventh in a row. How to reverse the trend and make Croatia a more pleasant place to live in is currently debated by presidential candidates. For this to happen it is not enough to speak with passion. A precondition for this is a lot of hard and unpleasant work called: reforms.

Carlos Pinerua, World Bank Country Manager for Croatia and Slovenia talks about the work facing Croatia. Mr. Pinerua, together with his colleagues recently presented a comprehensive document, focusing on Croatia’s return to a path of prosperity.  Just as his predecessors, he talks about issues that sound quite familiar, meaning that they have been postponed for years and are not being implemented. Even if Croatia may not be the best place for business, like most foreigners, this economist from Venezuela with rich international experience is impressed by its beauty.


Q: You have now been in Croatia for almost 4 months. Could you tell us about you most memorable impressions about the country? Have you come across some pleasant and some unpleasant surprises?

More than surprised, I have been impressed by all of what Croatia has to offer to its visitors—beautiful scenery, magnificent food and wine and, above all, an incredible love of the arts and culture. As part of our work here in Croatia, I have had a chance to visit Rijeka and Krk, where the economic potential of Croatia is clearly obvious. On a personal side, I visited Split (with my children) and Opatjia (with my parents) and only look forward to see more of this beautiful and welcoming country.

Q: One of your first statements was that Croatia needs a ‘social and political dialogue among all stakeholders because it will not be possible to continue like this for much longer’. What is your impression of this situation now and in which direction do you see it heading?

Croatia remains in a very tenuous equilibrium, with high unemployment (especially for the young), with no growth and with an increasing debt burden.  So far, this equilibrium seems to be holding because global interest rates remain at historically low levels. However, this is likely to change in not too distant future. Therefore, my view continues to be that a dialogue—some sort of “grand bargain”—among key stakeholders and leaders is needed to address the structural weaknesses of the economy before global conditions change.

Q: Most recent WB report: the Croatia Public Finance Review says that for the stability of public finances and for the economic recovery an adjustment of 4-5 percentage points of GDP is needed in the medium term. Do you believe that this can be done?

To stabilize the rise of public debt, Croatia would need to cut its primary deficit by 1.8 percentage points of GDP per year over the next three years. This is also Croatia’s requirement under the Excessive Deficit Procedure monitored by the European Commission. Why do we think it is achievable? Several countries in the EU have gone through fiscal consolidation episodes in the recent history; many in the order much beyond what is required for Croatia’s stability. The required adjustment in Croatia would be similar to the consolidation episodes of Sweden, UK or Ireland which all succeeded in parallel to minimize the social costs of such adjustments. Secondly, the current spending pattern offers significant scope for rationalization. At 47 percent of GDP in 2013, Croatia’s spending level was 5.2 percentage points of GDP higher than in its EU10 peers and there are spending areas where it is not only the size of spending, but the efficiency and effectiveness of this spending that is being questioned; i.e. the value for money Croatian taxpayers receive. The consequences of not stabilizing its public debt could further slowdown Croatia’s recovery prospects.

Q: In the report you use the terminology ‘right-sizing the government’, and indicate possible savings of around 2% of GDP. How would you organize such a reform?

At 12 percent of GDP, Croatia spends more on public administration wage bill than most other EU countries. At the same time, Croatia is rated comparatively low with respect to the effectiveness of its administration: World Bank governance indicators point to general weaknesses of the Croatian public administration in particular in terms of corruption, the rule of law, regulatory quality, and government effectiveness. The World Economic Forum's Competitiveness Report 2013-2014 ranked inefficient public administration as the top barrier for doing business in Croatia.  While improvements have been observed in various dimensions, notably as regards the enforcement of debt contracts, tax administration as well as company registration, gaps remain in terms of the number of days required to complete administrative procedures for starting a business, dealing with building licenses, registering a property, and enforcing contracts.

Q: How would you achieve these savings?

They could be achieved over the medium term through staff rationalization in local/regional and national governments to create a leaner, but more effective and service-minded administration. While doing this one has to focus on three important areas: (i) downsizing the organizational structures and operational procedures, and reducing the rigidity of remuneration system in the public administration which is largely based on seniority and not on performance; (ii) reducing the fragmentation of local and regional self-government units, which are expensive, but not self-sustaining; and (iii) reducing the creation of agencies. Finally, public administration is still politicized, leaving little room to build professional managerial level civil servants.

Q: In May WB approved a EUR75 million loan for the improvement of quality and efficiency of health services.  What was the main reason for this loan?

Although health outcomes are relatively good, they come at a high cost. Widespread underreporting of wages means that wage-based contribution revenues to finance the system are low. However, the contribution rate of 15 percent to finance the public system is also high. Hospital admission and occupancy rates are high by Western standards and no longer suited to the needs because the system was built mainly to deal with acute illnesses. Arrears in the health system, mainly from hospitals and pharmaceuticals, at around 1 percent of GDP, indicate ongoing weaknesses in public financial and system management. The health system’s sustainability is even more complicated by rapid aging. Since 2001, the 65+ age group has grown to be larger than the population aged 15 years and below. Non-communicable, chronic diseases and morbidity will continue increasing, with attendant need for additional health and long-term care services.

Q: The challenge to stop the ‘production’ of arrears remains?

The largest budget savings and efficiency improvements could be made in hospitals which are producing the highest costs in the system. The health system remains hospital-centric and the length of treatment in hospitals is too long. The National Development Plan for Hospitals, approved by the parliament, serves as a good platform to consolidate the hospital network, reduce the fixed costs of maintaining such a network so hospitals can focus on timely and effective service delivery.  Otherwise, a growing gap between resources available to the sector and the cost of service provision will stimulate the continuous production of arrears in the future.

Q: What do you think about removing the health system from the Treasury?

Removal of the Health Insurance Fund from the Single Treasury Account will not prevent the occurrence of arrears and will not reduce the unit cost of the system. It is primarily the management of hospital care that needs to be addressed.

Q: One of the recommendations you mention in the report for the pensions system is the rationalization of privileged pensions which are 2.4 times the amount of regular pension.  Could you be more specific? What would be included in the rationalization?

More than a dozen special and privileged pension schemes exist, fiscally exhausting the pension system and creating serious inequities. In 2012, privileged pension benefits for members of Parliament, government officials, and constitutional court judges were abolished, and the list of internal affairs personnel subject to accelerated service periods was trimmed to cover only hazardous positions. The long-term aging pressure will worsen the system dependency rate even further to 1 in 2032 and to 0.77 contributors for each pensioner by 2058. This compares to the countries in the EU with the lowest coverage, such as Spain and Greece. However, certain progress has been made with the recent pension reform.

Q: What else do you see as priorities to balance out the pension system?

Only 50 percent of Croatians aged 15 to 65 contributes to the system. Croatia suffers from low formal labor participation, a large shadow economy, at 25-30 percent, high unemployment, and early exit from the labor force, either through early retirement or disability. There should be a general shift towards putting people back to the labor market, entrepreneurship, away from inactivity and overreliance on the social safety nets.

Q: A consistent message conveyed to the Croatian authorities is to make better use of EU funds.

Croatia’s contracting rate of EU funds is reasonably high but in the early years of membership the EU Funds are likely to have a negative net impact on the budget accounts. In the first six years, the cash deficit could be around 1.8 percent of GDP annually on average.  This is similar to previous experiences of 2004 and 2007 entrants to EU. However, what is more important is that these funds are used effectively for projects that will generate long-term growth. 


Q: You specifically highlighted two sectors – agriculture and railways – as favorable candidates for EU funds. Could you explain why?

Agriculture and railways have been the largest recipients of subsidies – 1.5% of GDP out of 2% in total. However, there is little evidence that they have contributed to improving performance in these sectors. Instead, the overreliance on state aid has postponed the necessary restructuring of these sectors. The labor productivity in railways is now lower than ten years ago, and is almost half of that realized by European peers. This suggests that the size of the labor force is not optimal for the significantly reduced level of traffic, despite a continuous decrease in the number of employees since 2005. In agriculture, high share of small and subsistence-oriented agricultural holdings weakens overall labor productivity that is four times smaller than EU15 average. Compared to EU27, Croatia pursues a much more labor-intensive agriculture, and utilizes twice as many annual work units (AWU) per hectare (i.e. 0.16 AWU/ha, as a 2005-11 average).

These two sectors have at its disposal large additional resources available from the EU.  Around EUR 1.95 billion of funds could be earmarked to railways in 2014-2020 perspective. Railways will need to allocate at least EUR600 million for the total national contribution for railway projects in the next financing perspective, while at the same time reducing state aid. Agriculture and fisheries will receive around EUR3.7 billion in the same period.  The absorption of these funds will again very much depend on the institutional capacity, matching funds for co-financing and pre-financing ability.

Q: What do you expect in 2015, where are the biggest challenges?

The biggest challenge will be to sustain the fiscal consolidation efforts and reverse the low general trust in the ability of the economy to return to growth after six years of recession. We are expecting a mild recovery supported by the EU-funded investment cycle. Geopolitical tensions and the second-round effects on the Croatian economy from the developments in the main EU trading partners, monetary tightening of the Fed and the impact on the cost of funding for emerging markets all point to a need for Croatia’s more ambitious reform agenda in addressing fiscal vulnerabilities and rekindling competitiveness and growth.