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OPINIONAugust 29, 2022

In Croatia, the Obstacle to Faster Growth is not Dependence on Tourism, but Lagging Productivity

Jehan-Arulpragasam Country Manager for Croatia and Slovenia
Jehan Arulpragasam, World Bank Country Manager for Croatia and Slovenia. Photo: Sandra Šimunović/PIXSELL

Translated to English from the original interview published in Croatian.

Poslovni dnevnik: With your predecessors, we have been doing interviews with very similar questions for several years. The same topics are constantly coming up: mostly, there is a lack of reforms and recommendations on what should be done. You have been in Croatia for less than a year. What is your general view of the local economy?

Jehan Arulpragasam: I think that Croatia is a country of great potential, considering its geographical location and the potential of its people and human capital. With entry into the EU, now also the Eurozone, important changes have taken place for the better. I would say that the country is making slow but sure progress, despite a series of institutional obstacles. After the COVID crisis, Croatia recovered faster than other European countries, but long-term growth needs to be made stronger and more sustainable.

What are your expectations for the euro introduction in 2023?

I think that Croatia's entry into the eurozone makes a lot of sense because the country is a small, open, highly euro-ized economy, which carries out the bulk of its trade with eurozone members, so the disappearance of the exchange rate risk and additional integration is definitely a plus for the economy and trade facilitation. It also opens up the possibility of using the European Stabilization Mechanism in the event of a new crisis. The loss of monetary sovereignty is often mentioned as a negative aspect, but this risk is not so pronounced, because Croatia has already linked its exchange rate to the euro. It is understandable that people are afraid of inflation, but previous experiences of countries that have gone through this process suggest that this impact should not be so pronounced. We at the World Bank believe that the benefits of the euro far outweigh the disadvantages.

The euro adoption process was accompanied by expectations for strong reforms, but Croatia still has among the weakest institutions - only Bulgaria and Romania are worse. How much of a problem is this for a country in the monetary union? Did Croatia miss the opportunity for reforms?

No, I don't believe so. There are certainly structural and institutional problems that need to be tackled, but entry into the monetary union was not aimed at these issues. In this process, monetary management and fiscal responsibility were assessed, which Croatian authorities handled very well, even during the crisis. The accession to the EU at the time gave a great boost to reforms, but Croatia still has a big job to do with in-depth structural moves.

Croatia lags behind the eurozone average, but also behind members in the region such as Slovakia, not to mention Austria. With the existing growth rates, how quickly can we catch up to their levels?

Croatia is currently at 70% of the average income of the EU 27 members, which is not bad, but of course there is room for improvement. The recently published National Development Strategy sets the goal of reaching 75% of the average income in the next eight years, that is by 2030. At the World Bank, we believe that this is a realistic goal and that Croatia can achieve it, even exceed it. In the last few years, Croatia has successfully reduced the gap with the European average, and looking at 2021 data and the purchasing power parity, the country has surpassed one of the countries you mention, Slovakia. It is useful to observe how Croatia does relative to the average income of the EU 27 with a view to convergance. What is key is to focus on increasing the potential growth and living standards of all citizens. I believe that Croatia is moving in the right direction and that it can speed up convergence.

Is there a fear that the motivation for reforms could be 'deflated,' now that the Maastricht criteria have been met and entry into the eurozone has been confirmed?

I believe that the National Recovery and Resilience Plan (NRRP) is a strong motivation for the continuation of reforms, an instrument intended for recovery from COVID-19 and for member states to become more resilent during future crises. Croatia has 5.5 billion euros at its disposal, but the key here is that the disbursement of the funds is directly dependent on the completion of the reforms. The national plan envisages ambitious goals in the next few years linked to reforms and investments. The amount of approved funds is an important motivation for reform steps, and therefore I do not believe that the momentum could disapear, at least not now. The World Bank cooperates with the authorities by providing assistance to the successful implementation of the Plan.

How do you assess the National Recovery and Resilience Plan? What is capacity of the administration to absorb the funds?

Our assessment is that the Croatian Plan is quite ambitious and envisages some very difficult but key reforms, such as, for example, in the education system and moving to the whole day school model, changes in the wage system in the public sector and similar. All the planned reforms will have a long-term impact on Croatia's potential growth. The challenge lies in the implementation, not only of the reforms, but also of the announced investments, considering the war in Ukraine, inflation and the rise in construction prices. The implementation will be challenging for every country because it involves big reforms and large resources. We are here, ready to help.

When the recovery mechanism and national plans were created, the main thought was COVID. Today, it is the crisis related to the war in Ukraine, the energy shock, and inflation. Should the goals set by the plan be changed and adjusted?

No, there is no need. It is ironic that the instrument was to help with the recovery from the COVID shock, something Croatia did very well, and now a second shock has occurred. However, the ultimate goal is recovery and resilience regardless of the type of shock. It will be important for Croatia to have these funds available and to undertake reforms that will make Croatian institutions and the economy more resilient to shocks. The implementation of economic measures will be challenging in terms of managing the deficit and debt due to inflation, but joining the Eurozone will also be helpful with these matters.

During your career, you have worked in many countries and seen numerous examples from around the world. What is Croatia doing wrong to lag so far behind others?

In order for growth to accelerate, you need to have several things. On the one hand, the accumulation of capital and labor, and on the other, productivity. With the huge amount of capital coming from Europe in terms of investment, this will, according to our projections, increase growth rates in the next few years. As far as labor is concerned, Croatia is faced with great challenges, due to the decline in the number of inhabitants. Considering the situation in the labor market, it will be necessary to extend working life and increase labor force participation, which is lower than in other countries. Productivity is a very important issue that needs to be given more attention. The World Bank recently worked on a report on productivity and its links to growth prospects comparing Croatia and some other countries with Germany. The results were surprising, showing that the obstacle to greater growth is not the sectoral composition of the economy, but rather the significant lag in productivity in almost all sectors. In other words, if Croatia, like Germany, relied more on the manufacturing industry and less on tourism, the growth rate would increase but not as much as you would expect. What would really make a difference is an increase in the productivity of Croatian companies, which lag significantly behind German companies. And that is why we need to think about how to increase the productivity of the Croatian private sector.

In what way?

It is necessary to raise the skills and level of education of workers, to work on increasing innovation so that companies can go in the direction of digitization and the adoption of new technologies. The role of the state is to enable financing through HBOR and HAMAG BICRO and stimulate investments in new technologies. Then there is the justice sector which is essential in terms of transparency and creating confidence in the investment climate, as well as in the sphere of bureaucracy and the regulatory environment, because companies find it difficult to enter and exit the market. Finally, to make a jump in productivity, quality education is needed. It is necessary to strengthen the skills of current workers and all future generations, starting from early childhood to tertiary education.

What, in your view, would be a good example for Croatia to follow?

It would be good to look at other EU countries, for example, Slovenia, but there are good examples in every country. It is also useful to look beyond the borders of Europe. For example, I worked in Asia, in countries with a significantly lower average income than Croatia, even below the level at which Croatia and Yugoslavia were still in the 1970s. It is interesting because many of these countries, such as Indonesia, Vietnam and China, are looking for new ideas everywhere to 'leapfrog' and innovate in ways others may have not. From my experience, more developed countries often feel that they are 'doing fine'. If you are looking for solutions, it is good to observe what others are doing.

Inflation is out of control throughout Europe and the US, and there is no end in sight to conflicts, energy chaos, and soaring food prices. How long will inflation last, and what peak do you predict? What if the war lasts for years?

This is a very difficult question. The forecasts are constantly changing. We expected the pandemic and related costs to subside by early next year, but instead inflation continued to rise due to the war and problems in supply chains from and to Asia. It is hard to say how long the shocks will last. Our inflation forecasts for Croatia are close to those of the CNB (9.4% in 2022, op.a.), and developments in Croatia will depend on what will happen globally. Currently, we expect a gradual slowdown in inflation in 2023, but it will still remain above the multi-year average.

If the war lasts for years? Trade, citizens' incomes, tourism come into question, growth would slow down... Consumption and investments would decrease, and if there was an increase in interest rates, the costs of financing companies would increase leading to a rise in debt at the aggregate level. The result would be much slower growth, not only in Croatia but also globally, and as a result, the growth in prices would slow down. But that is not a scenario that we would like to see come true.

On the other hand, this crisis could also have some positive impacts, for example on the transition from fossil fuels and less dependence on some energy sources, and we could expect structural shifts in the global economy. Unfortunately, we don't have a crystal ball for predictions.

Inflation has been imported. Croatia is entering the Eurozone, so the CNB has no room for intervention. What can the Government do to preserve standards of living, especially of the poorest?

The government has already lowered the VAT on food and energy, but the fact is that inflation affects the poorest the most, because electricity, heating and food make up the largest share of their consumer basket. Given the fiscal constraints, there is not much room for further general measures such as tax relief. But what Croatia and other countries can do is provide targeted support to the most vulnerable groups.

In which sectors do we first need in-depth reforms, which haven't happened for years? Health, education, territorial division, the pension system, the labor market...?

Ideally, everything you listed. There are reforms that increase potential GDP growth and those that go in the direction of improving the level and quality of services to citizens, including the poorest, such as healthcare, while education reform, for example, brings a dual impact. If we would like to focus on reforms that increase growth in the long term, the most important are judiciary, business environment and education, and then all the other reforms.

The economy depends on people. Population decline and demographic aging are detected as problems without a coherent solution. Not much can be done in the short term, but what can the government do in the long term?

Labor is a key factor in the productivity of the economy and its growth, and in this context, the reduction of the labor force is problematic. Several things can be done. I mentioned the need to extend the duration of employment so that people do not leave the labor force early and to increase labor market participation. This will have to be done sooner or later, because it is critical for the country on many fronts. One of the solutions is to import workers from abroad, qualified and unqualified, which is happening all over Europe, and another is to try to bring back some of the people who have left the country in the last ten or so years. The most important thing is to provide good employment opportunities and remove artificial obstacles in the labor market.

Reform of the pension system has never been completed, there is a shortage of almost 300,000 workers in the private sector, and the largest part of the contributions of today's workers goes to the payment of current pensions, and not to their pension savings? Should we admit defeat and put everything back under the auspices of the budget, considering the projections of the amount of pensions from the second pillar?

Our position is that the pension system is one of those in which reform is needed because the current pensions are significantly below the average salary. We believe that saving for pensions in the second and third pillars is crucial and that the system should not be abolished. Returning savings to the first pillar, that is, to the budget, would mean that the state can spend the savings today, and burden future generations with the obligation to pay pensions. One of the things that the state did was to make the first pillar more attractive, which is why two billion kuna were returned to it last year, which is not a positive development in our view. The state of the pension system and its sustainability are a consequence of the situation in the labor market, including issues such as the shortage of workers, levels of contributions, and years of employment. The World Bank is currently cooperating with the Ministry of Labour, Pension System, Family and Social Policy on a detailed analysis of the entire pension system, which will propose recommendations for its improvement.


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