51424 v2 Key Messages The World Bank · There are a number of early signs of global recovery observed in the second half of 2009. Equity and real estate prices stabilized, trade and capital flows improved, investors as well as consumer expectations turned positive. Global industrial production has increased in the third quarter of 2009 as the U.S., Japan and EU joined the upturn and as the negative contribution to growth of falling inventories abates. EU10 · However, globally synchronized recessions are often long and deep and recoveries from these recessions are generally weak. Potential growth that follows is Regular · likely to be lower than in pre-crisis years. Government, corporates as well as households will Economic need to adjust their finances and investment plans accordingly. Primarily, they will need to rebalance their balance sheets and reduce excessive reliance on foreign savings. Report · Domestic policies are now key element in ensuring stability and stem the further growth of debt. The crisis has highlighted the need to accelerate fiscal and structural reforms. In the case of Croatia, this would Croatia translate into accompanying the short-term fiscal measures with the appropriate long-term fiscal Supplement adjustment reforms. · The recession has worsened labor market outcomes and will set back the poverty reduction gains from the past. The economic crisis is affecting foremost young workers, as enterprises often reduce employment on the basis of "last in, first out". · External imbalances are undergoing sizable adjustments and in the case of Croatia are likely to October 2009 lead to the current account deficit shrinking to around 6 percent of GDP for 2009. Against the background of this large external adjustment, earlier fears of inability to refinance external obligations have diminished. · However, large debt service costs of close to 20 percent of GDP in 2010 require generating higher domestic savings. External Environment After the sharp contraction following the crisis outbreak, economic activity in the EU10 countries and Croatia has started to stabilize in the second half of 2009. The recession deepened in the second quarter of 2009 in most of the countries in the region in response to the difficult external environment and tighter credit conditions. Year-on-year growth dropped from - 3.8 percent in the first quarter of 2009 to -4.8 percent in the second quarter 2009, compared to reduction from -5.3 percent to -5.6 percent, respectively, for the EU15. Poland is the only EU country whose economy has expanded throughout the last three quarters. Most of other central European countries saw a contraction of 5 to 10 percent of GDP, with the exception of the Baltic countries, where the earlier started contraction aggravated further to 15 to 20 percent of GDP. The downturn was largely driven by a sharp contraction in investment, as companies scaled down their production capacities in view of low access to financing and uncertainty about future prospects. In contrast, public consumption boosted growth in most countries, as governments bolstered the economy with anti-crisis measures. Future growth is likely to be lower than in Table 1: Global growth prospects pre-crisis years. Furthermore, the outlook is weaker for those countries that need to 2009 2010 2011 restructure their economy as capital inflows World 1.1 3.1 4.2 remain low. Large output gaps and modest United States 2.7 1.5 2.8 increases in commodity prices are set to keep Japan 5.4 1.7 2.4 inflation subdued, and weak domestic demand and shallow capital flows are likely to China 8.5 9 9.7 maintain current account deficits at sharply European Union 4.2 0.5 1.8 reduced levels compared to before the crisis. EU15 4.2 0.4 1.5 Still, in spite of the recent improvements in EU10 4.2 0.9 3.6 global financial markets, heightened financial Source: IMF, World Economic Outlook October 2009, World strains could return, as the slowdown in Bank staff calculations economic activity reduces profit margins of the corporate sector and incomes of households, and thus non-performing loans increase. The stabilization of financial markets is continuing with a return of confidence and risk taking. Strong policy action has helped to avoid a systemic regional crisis. Parent banks have continued to support their subsidiaries and viable local banks have managed to stay in business. Strong parent and subsidiary links have proven to be a source of resilience in the region, as cross-border flows to the region contracted less sharply than in other emerging market regions. Output Developments The rebound of global economy has started, but the recovery in the EU10 region and Croatia will likely remain weak. Governments and private sectors will need to rebalance their balance sheets and reduce excessive reliance on foreign savings. Countries in the region are projected to contract by around 4.2 percent on average in 2009 and to grow by around 1 percent in 2010. 2 Economic activity in Croatia declined strongly Figure [1]. GDP growth rates (in %) and relative in the first half of 2009, by 6.5 percent y/y. contribution of domestic and foreign demand, in The decline was broad-based, with most percentage points components facing double-digit declines. 12 Exports dropped markedly due to deteriorated 9 external demand, particularly from the EU 6 countries, while unfavorable financing terms as 3 well as reduced demand sharply reduced both 0 corporate and household investments. Personal -3 consumption recorded a decline by 9.7 percent -6 in the first half of 2009, partially due to -9 Domestic demand negative welfare expectations as well as due to Net foreign demand -12 GDP early adjustments on the labor market. In -15 contrast to personal consumption, government Q1/06 Q2/06 Q3/06 Q4/06 Q1/07 Q2/07 Q3/07 Q4/07 Q1/08 Q2/08 Q3/08 Q4/08 Q1/09 Q2/09 consumption maintained a positive growth rate, albeit somewhat smaller than in the previous Source: CROSTAT quarter due to the reduction of public administration salaries by 6 percent. Figure [2]. Retail Sales (2005 = 100, SA, 3MA) and Figure [3]. Industrial production and manufacturing VAT collection (HRK million, 3MA) (2005 = 100, SA, 3MA) 120 110 4.5 Retail sales (left axis) Latest: Aug-09 105 Manufacturing 4.0 100 110 3.5 Total 95 3.0 90 100 VAT collection (right axis) 2.5 85 Latest: Aug-09 Lates t o bservation: Sep -09 80 2.0 90 2005 2006 2007 2008 2009 2005 2006 2007 2008 2009 Source: CROSTAT The pace of economic decline has slowed down over the summer months, and economic conditions remain weak. Both production and demand based indicators (manufacturing, industrial production, construction, retail sales and imports) continue to register declines as the private sector adjusts in the aftermath of the financial turmoil. In the third quarter, industrial production declined by 9 percent over the same period last year, although more moderate than in the previous quarter. Real retail trade turnover declines continued narrowing in the third quarter of 2009. Nevertheless, in the period from July to August the contraction (­14.0 percent) was somewhat lower than in the previous quarter. Overall, the estimated contraction hovers around 5 percent. Although there are some initial signs that the recession may be bottoming out (as seasonally adjusted data show) the outlook for growth in 2010 is subject to high uncertainty. It will strongly depend on the evolution of external demand for Croatian goods and tourism services, and foreign capital inflows. The government consumption contribution to growth is expected to turn negative as announced by the Medium-Term Fiscal Guidelines. The growth projection for 2010 currently stands at 0.5 percent. Labor market and wage developments The recession has worsened labor market outcomes. Still, across the region, the deterioration in the labor market was more modest than the deterioration in economic activity. The economic 3 crisis is affecting foremost young workers, as enterprises often reduce employment on the basis of "last in, first out". With the slowdown in economic activity, labor market conditions in Croatia have also worsened. The latest available September 2009 data on newly registered unemployment showed a sharp increase by around 40 percent y/y, which with declining employment led to unemployment rate of 14.7 percent. The number of unemployment benefit claimants rose by 25.4 percent in the same period. Job prospects have become meager as the number of job vacancies fell by over 37 percent. The labor force survey (LFS) unemployment rate (at 8.9 percent y/y in Q2) showed an increase by one percentage points compared to the same period last year, albeit somewhat lower than in the first quarter of 2009 pointing to strengthening of informal employment. The employment dropped by 27,000 compared to Q2 2008, with tourism, manufacturing and construction industries the most affected. The employment rate dropped in Q2 of 2009 to 56.5 percent from over 57.6 percent a year ago. Figure [4]. Change in Number of Employees, Figure [5]. Real Net Wage Adjustment, 2000=100 January ­August 2009, y/y 6.8 Accommodation and food service 140 1 6.1 Manufacturing 2.6 Construction business sector (lhs) 1.8 Minning and quarrying Real net wage (I/2000=100) 1 1.5 Transport and storage non-business sector 1.3 Public administration (rhs) 1.2 Transport and storage 135 1 1.1 Trade 1.0 Agriculture 0.8 Professional activities 1 0.6 Information and communication 0.2 Administrative&support activities 0.2 Water supply 130 1 0.2 Other services activities Real estate activities 0.6 Education 1.9 1 Human health and social work 2.4 Financial and insurance activities 2.6 Arts, entertainment&recreation 4.6 125 1 7 7 7 7 8 8 8 8 9 9 9 0 - 0 - 0 - 0 - 0 - 0 - 0 - 0 - 0 - 0 - 0 - 8.0 6.0 4.0 2.0 0.0 2.0 4.0 6.0 n a r p l u J t c n a r p l u J t c n a r p l u J J A O J A O J A Source: CROSTAT Wage adjustments in the private sector prevented a stronger fall in employment early in the year. Business sector wage growth was kept at real freeze in January-July period, while public sector growth still exhibit a 2.7 percent real increase despite the April roll-back of the earlier in the year given 6-percent rise. The newly introduced crisis tax, therefore, will pull down the rate of change in wages over the coming months. According to calculations by the CBS, the crisis tax has on average cut the average net salary in Croatia by 2.8 percent. Inflation and monetary policy Inflation in the region has fallen sharply in line with the rise in the output gap, similar to trends in the euro area. However, the pace of decline differs according to the exchange rate regime. The reduction in inflation is more pronounced for countries with fixed exchange rates, as improvements in competitiveness require "internal" devaluations. 4 Croatia experienced a large adjustment in inflation rate. The inflation rate in the first Figure [6]. Quarterly CPI growth rate, y/y nine months stood at 2.6 percent, compared to % 6.7 percent in the same period in 2008. There 8.0 were no significant inflationary pressures from 7.0 the increased VAT and excise tax on mobile 6.0 telephony, as they were offset by the lower 5.0 price of energy and food. Consumer prices, 4.0 when corrected for energy and food, were 3.0 higher year on year by 3.1 percent. The 2.0 industrial PPI inflation recorded a 0.6 percent 1.0 Q1 2002 Q3 2002 Q1 2003 Q3 2003 Q1 2004 Q3 2004 Q1 2005 Q3 2005 Q1 2006 Q3 2006 Q1 2007 Q3 2007 Q1 2008 Q3 2008 Q1 2009 Q3 2009 decline in the January-September period of 2009, which is likely to impact the stability of CPI in the rest of the year in case no further global commodity price shocks occur. The inflation projection, for 2009, remains Sources: CNB, CROSTAT somewhat below 3 percent. Monetary developments during summer months of 2009 were marked by a rise in net foreign assets and a fall in net domestic assets of commercial banks. Under these circumstances, total liquid assets (M4) went up slightly, primarily thanks to the growth of foreign exchange deposits (tourism receipts). Savings deposits stabilized (with an annual increase of some 4 percent by July 2009) after a fall during October 2008, while awareness of the currency risk heightened with FX placements rising back to 70 percent and FX deposits to two-thirds of the total. Deposits denominated in foreign currency account for 75.6 percent of total deposits, above the ratio of foreign currency and foreign currency denominated loans to overall loans (70.1 percent). Lending activities of banks to the private sector continued declining. By August 2009, bank placements went down to 3.3 percent y/y. Broken down by sector, the slump in bank lending was particularly evident in the household sector. Loans to households had been declining since the beginning of the year; with their annual growth rate falling to only 2.1 percent at the end of August. Household loan demand dropped due to increased insecurity regarding the future employment and wages, cost of borrowing as well as future developments in the real estate market, which induced some households to postpone a decision to purchase a dwelling. In contrast, limited supply remained oriented towards more secure financing of government borrowing requirements. After the exceptionally strong growth since October 2008, banks' net claims on the central government observed a downward trend in June largely due to the inflow of assets from the issue of a government Eurobond. However, In July and August credit liabilities went up again and government deposits again declined, increasing banks' net placements to the government by twice the balance at the end of the same month the year before. Figure [7]. International Reserves and Banks' foreign exchange reserves, billion EUR Official FX reserves are at adequate levels, billion EUR supported with a one-off boost from the IMF 16 allocation. The FX reserves of the central bank 14 increased by 1.9 percent, compared to end- Bank's FX reserves CNB's international reserves 12 2008, to EUR 9.3bn at end-August. As for commercial banks, their foreign reserves were 10 down by 7.9 percent y/y to EUR 4.3bn, mainly 8 due to the changes in the monetary framework. 6 4 The aggregate capital adequacy ratio of the 2 Croatian banking system remains strong. After 0 temporarily declining to 14.2 percent at the X X X X X X VII VII VII VII VII VII VII I 2003 I 2004 I 2005 I 2006 I 2007 I 2008 I 2009 IV IV IV IV IV IV IV end of 2008, due to regulatory increase of weights for calculating credit risk arising from FX risk, it returned to 15.9 percent by June Source: CNB 5 2009 due to retention of earnings from previous year and the change in structure of the loan portfolio. Loan-loss provisions grew noticeably but their increase still did not follow the rise in NPLs. Unsurprisingly, the nonperforming loans ratio reached 4.9 percent at end-2008 and increased further to 6.1 percent by June 2009, together with a double-digit growth in provisions. Well capitalized Croatian banks have prevented major negative reactions from depositors and investors. Table 2: Selected Financial Sector Soundness Indicators 2005 2006 2007 2008 Q1 2009 Q2 2009 ROAA before tax 1.65 1.50 1.57 1.60 1.56 1.55 ROAE after tax 15.1 12.4 10.9 9.9 9.3 9.3 CAR 14.7 14.0 16.4 15.2 15.4 15.9 Leverage ratio (equity capital/total assets) 8.8 9.7 11.5 13.0 13.7 14.0 Nonperforming loans to total loans 6.2 5.2 4.8 4.8 5.2 6.1 Loan-loss provisioning 3.7 3.0 2.6 2.4 2.5 2.7 FX denominated and FX indexed deposits to total deposits 75.6 78.5 71.0 73.2 75.0 75.8 FX denominated and FX indexed loans to total loans 79.3 72.4 62.5 66.2 68.3 69.3 Source: CNB Public finance After years of improving fiscal balances on the back of a strong economy, most countries in the region are now facing large and growing fiscal deficits. Faced with declining revenues and higher spending pressures, countries have undertaken substantial adjustments in fiscal policies. Improving fiscal frameworks to mitigate the fallout from the crisis, anchor market expectations and ensure fiscal sustainability is a critical element of stabilization policies. Fiscal policy in Croatia underwent a serious stress from late 2008, as revenues underperformed due to the economic slowdown and the decline of imports. Through a combination of expenditure reduction, amounting to 2.1 percent of GDP (HRK6.9 billion) and revenue increase, amounting to 0.4 percent GDP (HRK1.4 billion), the consolidated general government deficit is set to increase from 0.9 to 2.9 percent of GDP (according to the national fiscal methodology)1. Without these measures the deficit would have widened by additional 2.5 percentage points of GDP. The general government debt reached 32.5 percent of GDP by mid-2009, while with guarantees grew to 47 percent of GDP. Overall public and publicly guaranteed debt is expected to increase further towards 50 percent of GDP by year-end. Government efforts to bring public finances back to sustainability through the 2009 Budget revisions helped sustain macro stability through securing timely and adequate financing for 2009. After the first round of expenditure cuts early in a year, mostly related to delaying new capital projects and achieving savings in current expenditures, the July 2009 spending cuts were almost equally distributed across spending categories. The largest reduction affected: (i) salaries (a 10-percent reduction in government officials' salaries, the rolling back of the 6-percent rise granted to public administration earlier this year, public employment freeze and a ban on setting up any new administrative units); (ii) material expenses (the suspension of the purchase of new vehicles, the limitation of the use of official vehicles, credit cards and mobile phones, the reduction of representation costs in all state bodies by 80 percent); (iii) categorical social benefits (sick leaves' reduction, increase in health co-payments and premiums, abolition of free-of-charge textbooks, transportation and dormitories, reduction in privileged pensions of MPs, constitutional court judges and government officials, pension indexation freeze, reduction in replacement rate for unemployment benefits), (iv) transfers for railway and road infrastructure investments with low rate of return, and (v) subsidies to railways. There was an upward adjustment to satisfy recent farmers' request. Additionally, the Government adopted several decisions from April to September 2009, dealing with cost rationalization and financial sustainability across all public enterprises. 1 According to GFS 1986, CGG deficit would rise from 1.3 to 3.2 percent of GDP. The overall public sector deficit, which includes off-budget items (Croatian Highways and pensioners' debt repayment), would reach 3.8 percent of GDP, instead of potential deficit of around 6 percent of GDP in the absence of revisions. 6 They include among else a 10-percent reduction in the wage bill, reduction in other operating costs and a plan for divestiture of non-core assets. Increasing number of requests to protect the affected industries by a global decline is putting additional pressure on the government to protect its finances and at the same time mitigate the social impact of the downturn. Inability to reach social consensus on social rights' adjustments, led the government to agree with social partners on a so-called `solidarity tax'2 introduction of which would bring about 0.2 and 0.6 percent of GDP in new revenues in 2009 and 2010, respectively. This measure coupled with increased excises on personal vehicles, other motor vehicles, vessels and aircrafts, administrative fee on revenues from mobile telephony, and increase in the VAT rate (from 22 to 23 percent) led to a partial recovery of the revenue losses stemming from declining compliance and economic activity amounting to 0.4 percent of GDP in 2009 (and around 1.4 percent in 2010). Further fiscal consolidation is expected over the medium term, as announced by the Government in its Fiscal and Economic Guidelines for 2010-2012, which is the basis for establishing the 3-year rolling budget, for the first time aimed for mandatory enactment by Parliament. Given the sharp rise in public and publicly guaranteed debt in 2009, the Government is preparing additional savings measures to be applied from 2010 onwards. Fiscal guidelines suggest a recovery of current and primary surplus, and thus stemming the further growth of public debt, by 2012 despite growing interest payments. Table 3: Medium-Term Fiscal Framework, 2008-2012, % of GDP 2008 2009 2010 2011 2012 o uttu rn e stim a te p la n p la n p la n T o ta l r ev e nu e 39.8 38.5 37.8 36.5 35.8 T a x es 22.3 20.9 20.9 19.9 19.5 S o cial co ntribu tio n s 11.9 12.2 11.9 11.7 11.6 G r an ts 0 .2 0.3 0 .3 0 .3 0 .3 R ev e n u e fro m a ssets 1 .9 2.1 1 .6 1 .6 1 .5 A d m in istr ative fee s 2 .9 2.6 2 .6 2 .5 2 .4 O th er r ev e n u e 0 .2 0.2 0 .2 0 .2 0 .2 S ales o f n o n fin ancia l a sse ts 0 .4 0.3 0 .3 0 .3 0 .3 T o ta l e x pe nd itu re s 40.7 41.4 40.1 38.7 37.2 C o mp e n satio n o f e mp lo y e es 7 .3 7.7 7 .5 7 .3 7 .1 U se o f g o o d s a n d se rv ice s 5 .0 4.9 4 .7 4 .5 4 .3 F in a n cial ex p e n d itur es 1 .7 1.7 2 .0 2 .0 1 .9 S u b sid ie s 2 .4 2.4 2 .1 2 .0 1 .9 G r an ts 0 .6 0.7 0 .5 0 .5 0 .5 S o cial benef its 17.8 19.2 18.8 18.0 17.3 O th er e x p en se 3 .2 2.7 2 .6 2 .6 2 .5 A c q u is ition o f a sse ts 2 .6 2.1 1 .9 1 .9 1 .8 T o ta l d ef icit -0 . 9 -2 . 9 -2 . 3 -2 .2 - 1 .4 Note: CGG, national methodology Source: Ministry of Finance, September 2009 Medium-Term Fiscal Guidelines Short-term savings will need to be accompanied by the appropriate long-term adjustment measures. The main measures on the spending side that are expected to be undertaken in the next three years include: (i) continued moderation of the wage bill with a rise contained below 2 and 4 percent nominally in 2011 and 2012, respectively; (ii) further reduction of subsidies towards 1.6 percent of GDP by 2010 with shipyards, railways and agriculture bearing the cost; and (iii) 2 Special tax on salaries, pensions and other income (known also as crisis or solidarity tax) applies 2% on net income between HRK 3,000 and 6,000 and 4% on net income above HRK 6,000 (incomes below HRK 3000 are exempted). The tax applies until the end of 2010 (for self-employed by February 2011) and is foreseen to bring HRK 755 million in 2009 and HRK 2.1 billion in 2010. At the same time, the Act on the Special Tax also suspends the indexation of pensions for the period January-December 2010, which is estimated to bring HRK 630 million of savings on pension payments in 2010. 7 reduction in social transfers as a result of containment of categorical benefits (among else veterans' benefits). The highest risk to this strategy comes from contingent liabilities related to shipyards. To that end privatization tenders for six state-owned shipyards were issued in July with two valid bids submitted, while the second round of the tendering process is expected to commence before the year-end. External vulnerability The adjustment in trade balances is leading to a welcome improvement in current account balances. The dwindling of capital flows has made large current account deficits untenable for EU10 countries and Croatia. Current account deficits are projected to contract significantly or, in the case of the Baltic States, to turn into surpluses. The adjustment in capital flows is also visible in the change of the external debt structure. High current account deficits from the past Figure [8]. External imbalance are undergoing significant adjustments. Croatia's external deficit in the first half of 8 6.4 7.0 5.7 2009 amounted to EUR 2.7bn on a rolling basis, 6 4.4 3.1 4 declining by 35.7 percent y/y (to 5.9 percent 2 2.0 1.9 of rolling GDP). The fall of deficit is ascribed to 0 the adjustment in foreign trade in goods (with % -2 -4 -0.6 -0.1 trade deficit declining by 15.1 percent y/y), -6 -3.2 -4.4 -5.5 and a stagnation in the exchange of services. In -8 -7.5 -6.3 -6.9 -7.6 -5.9 Jan-Aug, total exports dropped by 32.3 percent -10 -12 -9.3 y/y to EUR6.6 billion, but due to a 37 percent 2001 2002 2003 2004 2005 2006 2007 2008 H1 y/y plunge in total imports to EUR13.6 billion, 2009 the trade gap for the period shrank by 40.9 CAB Non-debt creating inflows percent y/y to EUR6.9 billion. Source: CNB, own calculations Parent banks have continued to support their local banks and the bank-related capital inflows have remained stable. Net FDI inflows recorded a decline of 35.3 percent in the first half of 2009 on a rolling base. Portfolio investments were negative and a consequence of financing needs of the Government (repayments of Eurobonds and samurai bonds and new issue of EUR750 million worth Eurobonds). The CAD is expected to gradually decline towards 6 percent of GDP with growing FDI to CAD coverage coming mostly from reinvested earnings of foreign-owned corporates and banks and inter-company lending. Table 4: External Debt developments 2007 2008 Q1 2009 Q2 2009 Gross external debt (in % GDP) 76.9 83.1 85.1 88.5 o/w Government 12.5 8.8 7.9 9.0 o/w Banks 20.7 21.3 21.8 22.5 o/w Other sectors 34.4 42.3 43.9 44.9 o/w Intercompany lending 9.2 10.8 11.5 12.2 Net external debt (in % GDP) 40.3 49.3 55.1 56.4 Short term debt (in % of overall debt) 13.3 13.7 11.3 12.2 Short term debt (in % FX reserves) 47.1 59.2 50.2 54.8 Gross external debt (at EUR 40.8bn) increased to 88 percent of GDP by June 2009 (from 82.6 percent of GDP at end-2008). The acceleration of debt to GDP ratio was mainly due to estimated annual nominal GDP decline, while growth of debt since December was kept at 3.7 percent. With the diversion of corporate sector for refinancing at home, its debt grew by EUR 0.7bn in the observed period, which was several times less than in the first six months of 2008. In the observed period, foreign liabilities of commercial banks went up (EUR 0.3bn) in contrast to the first half of the year, when they decreased. This was due to a rise in long-term deposits of non-residents, which exceeded the parallel substantial decrease in short-term sources of funding due to the outflow of currency and deposits and repayment of short-term loans. Public sector debt (including the government sector, public enterprises, mixed-ownership enterprises and the HBOR) went up by 8 EUR 0.3bn due to the rise in foreign liabilities of public and mixed-ownership enterprises and HBOR. In 2010, overall debt service will amount to EUR9.6 bill (or 19.8 percent of GDP). 9