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OPINION February 23, 2018

If Growth Rate Drops to 1.3%, Croatia Will Catch up with Austria in 58 Years

Interview with Arup Banerji, World Bank Regional Director for European Union countries for Poslovni dnevnik, published on February 23, 2018.

Arup Banerji, World Bank Regional Director for European Union countries, covered many countries throughout his career, including Romania and Bulgaria, countries which recently surpassed Croatia in many economic indicators.

Did we fail in the transition process, what did others do better and is the euro our last chance to jump on the train of converging with the EU, Banerji explains to Poslovni dnevnik

Poslovni dnevnik: The economy is expected to slow down from 3% to 2.7% in 2018. Has Croatia lost its recovery momentum?

Arup Banerji
Arup Banerji: Think of where Croatia started from: there has been a big recovery in the past six years from the depths of the crisis. The challenge are not year-to-year fluctuations, which will happen due to internal and external reasons. The biggest challenge Croatia faces is convergence to the EU. If the growth rate would slow down to 1.3%, close to its potential growth rate, you would need 21 years to catch up with the current levels of per capita income in Slovakia or 58 years to catch up with Austria. 

If you can keep a 3% growth rate, then you will catch up with Slovakia in 9 years and Austria in 26 years. Therefore, the real challenge is the potential growth. Croatia is also challenged by demographic components; the aging population and emigration. A counterbalance to this is productivity. That is where Croatia needs to catch up with its neighbors and countries it aspires to; by improving its competitiveness and human capital in order to boost its potential growth rate.

PD: So how do you increase the productivity?

AB: That is the underlying question for all countries that are reforming, including new EU members. For example, the Baltic countries improved their internal business climate in a very fundamental way, by improving their competition policies, allowing new businesses to start up and grow, by investing wisely in innovation (not just throwing money into it), by boosting the human capital and improving education system. That is how an innovation eco-system is created allowing for a bright person having a bright idea to start a company and make it grow and thereby respond to the demands of the 21st century.  The road to get there can be through home-grown innovations (like in Estonia, Romania and Bulgaria) or through value chains, like in Slovakia and some parts of Poland where innovations come from Germany and the world. There is no simple answer but this is a matter of a comprehensive, thoughtful system of innovative policies that span education, public services and the business environment.

PD: It seems that sectors which are affected by EU trends (tourism, hospitality, retail and partly transport) are growing significantly faster (5%YOY) than those primarily dependent on government-led reforms (industry, construction, agriculture - 1,5 %), the slowest in the entire EU. What does this tell us about the health of the Croatian economy?

AB: Let's take a step back and see what Croatia's biggest advantage is: this is one of the most beautiful countries in the world. If everything remains the same, tourism is going to assure Croatians a steady flow of income, but this sector has benefited by the fact the neighborhood has been unsettled. Tourists that usually used to go to Turkey or Egypt are now turning to Croatia, but this is not a permanent solution. Croatia needs to  build its innate competitiveness through a comprehensive reform program that strengthens public institutions, improves the flexibility of labor market so firms can hire people easily or let them go, supported by a social safety net so people are not hurt.

Croatia needs to continue improving its competition policy so that a few large firms, including state-owned enterprises, are not dominating the economy, allowing new firms to enter the market and grow. This is not easy and yet it is not a rocket science.

PD: In the past 20 years, Croatia grew on average by 1,7%, Romania by 3% and other successful transition economies by more than 4%. Romania has achieved a higher GDP per capita than Croatia. Does this mean Croatia has failed in its transition?

AB: It is too early to make that judgment. Let's also unveil how other new EU countries have grown and how sustainable that growth is. In the history of the modern world, Poland, except for South Korea, is the fastest country to move from a middle income to a higher-income status. That is because it implemented broad-based fundamental set of reforms that encouraged the private sector to grow That is a very sustainable way of growth based on investment and fantastic absorption of EU funds. Croatia has the opportunity to do the same.  On the other hand, Romania was the fastest growing economy in Europe last year, with growth driven a lot by consumption. Pro-cyclical fiscal policy gives economy a boost but over time, growth rates cannot be sustained without adequate investment levels.  The lesson for Croatia from Romania is that you can always generate little bursts of growth by the pro-cyclical fiscal policy, but if you would like to do the transition the Polish way, you need much more systematic investments and to take full advantage of the EU funds.

PD: Is a pro-cyclical driven burst what is going on at the moment in Croatia? While the government boasts of fiscal results, EC warns of the structural worsening, with Agrokor as the looming risk.

AB: No, actually not. The fiscal consolidation has been one of the biggest achievements in the last three years. The debt-to-GDP ratios have been falling continuously. For 2017, we will probably see even a small budget surplus, or at least a balanced budget which was not what we expected before. We expected the deficit of over 1%. I think that the current Finance Minister Marić and the Government are doing a very good job in fiscal consolidation. The trick is not to be tempted and stop with the consolidation. One way in which countries in Europe carried out the adjustment is by just squeezing the tap closed, including on investment,  but this way you hurt the economy because essentially you are prolonging recovery. Croatia is on the right path towards reducing the structural deficit by lowering the cost of servicing its debt, if current trends continue.

PD: Is the fiscal consolidation quick enough?

AB: The trend right now is very much in the positive direction, the question is how long can it be sustained. The problems should be dealt with while the situation is good – which is now. With the decent growth rates that Croatia has been enjoying over the last years, this is the time to bring the debt down and the pressure cannot be relaxed. You still have close to 80% of GDP in debt. If the trend continues, Croatia might decrease the debt to 60-65 % by 2020, but this will require "the pedals to be kept on the accelerator" and any thinking "we are on the right path and the pressure can be let off" would be a mistake.

PD: In a relatively short period of time, Bulgaria and Romania managed to catch up with us, even surpass us in many indicators. What did they do better?

AB: They started addressing many of the deep structural questions, including the role of state-owned enterprises. For example, Romania unbundled the energy sector. It separated generation, transmission and distribution companies, and then privatized all of them. Energy tariffs moved to much more normal levels and they are not heavily subsidized by the state.

Thereby it sent a signal to foreign investors "come and invest in these industries, you'll get proper returns.” Now, there’s a boom of investors. Bulgaria is going the same way. For all of the countries in the region, with a legacy of socialism and a state-dominated economy, addressing the issue of SOEs is one of the biggest challenges.

At the same time, new industries are growing. If you go to Timisoara or Sofia, you see start-ups that were built from nothing by entrepreneurs into high tech firms and then sold them to Silicon Valley for millions of dollars. That is the spirit that Croatia needs much more.

Privatization is not the cure for everything.  It is a matter of making these companies run according to normal business rules.

PD: But, isn’t it a political decision?

AB: Yes, but also an economic one. The question is how much productivity you expect. A good example in Croatia is in the road sector. The World Bank has partnered with Croatian government to address the debt of over 5 billion euros. The government together with the road companies put together a sector strategy for how these companies will be better managed, stop accumulating arrears and do the reforms. This is a process that has just begun, but one of the most heartening results I saw was the placement of the bond of over 1 billion Euro, with the 12-year tenure and the lowest interest rate ever because the market recognized the commitment to the reforms. These are not shock reforms and they will be done in the long run. More of these sorts of measures are needed across all sectors.

PD: Do you think addressing the problem of poorly managed SOEs would lower the (perception) of corruption?

AB: The challenge is how to manage these companies transparently. A privatization is often the key, but this is not always the case. There are many countries, like Australia and New Zealand, that have imposed strict budgetary rules, and if there are shady deals happening, the board gets fired. That sort of government oversight is, at least, a prerequisite for any transparent SOE.

PD: With euro adoption, a signing of The Fiscal Compact was also announced. Then it turned out to be 'a paper tiger' since Croatia requested an exemption for key chapters. Was that a missed opportunity?

AB: The euro adoption is a huge opportunity because of the process which allows Croatia to implement deep reforms.  Do not think of a particular date and rush towards the euro. Take the opportunity of the path to the ERM-II to strengthen the institutions, the flexibility of the labor market, the competitiveness, so that when you adopt the euro, the economy is strong enough to withhold the lack of flexibility that is entailed by it giving up monetary policy. Euro adoption is a matter of pride for any country, and countries do it to become full-fledged EU members. Still, it is important to heed the warnings of countries that have had incomplete transitions and the price they paid when the shock hit. The problem is not the good times, but the inevitable bad times and how resilient is the economy to recover from that.

PD: With the 8 billion of health care arrears, problems in the pension system, a series of fiscal risks (ranging from Agokor, commercial banks' law suits, lost rulings). What is your view on the possible VAT reduction to 24 percent?

AB: The 25 percent VAT in Croatia is high. But more fundamentally, the question is not the level of VAT but whether a small reduction brings enough benefits to the broader population. If you have a much stronger economy and sustained growth, then you can tweak the VAT rates. If growth rates are not sustained, the cost to the budget may be outweighed by the small benefits.

I don't have a strong opinion whether the rate should be 25 or 24%, but I would urge the Government, as I'm sure it's doing, to balance the risks and advantages. VAT affects the poorest sections of the population the most, and it is important to think about measures that can be taken to protect those groups. 

PD: The notion of dismantling the 2nd pension pillar has been viewed as extremist, but estimates say that the private sector lacks 280,000 jobs for sustainability. How do you asses the future of the pensions system? Do we need to mend the current one or tailor a new one, like the III. pillar in Slovenia?

AB: The aging challenge is such that no country in Europe, including the richest countries, can fully depend on the first pillar, where younger generations pay for the older. The number of people who are old is increasing, there are fewer younger people, partly due to emigration (like Croatia) and partly to a drop-in natality rates.  

Any pension system solution has to look at other pillars to make sure that any one of us can have a dignified retirement.

Compared to many of the other countries in Central and Eastern Europe, the second pillar in Croatia is actually working well. What is required are some parametric reforms for the first pillar, to make it more sustainable. For example, providing people with opportunities to work longer, discouraging early retirement to reduce the pressure to the system. The second pillar also needs reforms related to improving investment strategies and lowering of the administration fees these companies charge. Finally, there has to be more exploration of additional options to incentivize people to save for themselves and not to just depend on what the government is giving them. There are no easy solutions, but Croatia should explore all options.

PD: Health sector is facing similar problems with debt accumulation and it is ranked at the bottom of the EU. How can these problems be resolved?

AB: In the twenty years between 1994 and 2014, there has been a dozen or more financial rehabilitations in the sector and yet arrears still amount to 0,7% of GDP, calling for a large number of reforms. To begin with, looking at which hospitals are necessary and for what purpose. Also, across the region and in Croatia as well, the emergency services are often used almost as a substitute for a normal care, which is extremely expensive. But, most of all, what is needed is fiscal probity, holding hospital administrators and local officials responsible for not mounting up arrears without compromising the health care.

PD: How do you assess the 16-month mandate of PM Plenković's Government in terms of taking advantage of the reform potential?

AB: Prime Minister Plenković has said that this is the year of reforms. I do want to highlight the areas where we have been heartened by the direction of reforms. As mentioned before, the fiscal consolidation and the road sector. But there is not one sector for which we can say there is no need for reform. One of the big challenges is in improving the welfare of people in Slavonia, which is the poorest region and we are working with the government on that. The direction of reforms is heartening, but there are huge challenges ahead of us.