98803 MACRO MONITORING REPORT Q3 2015 CROATIA \ After six years of recession, Croatia returned to growth in early 2015 supported by external demand and personal consumption. These two factors on the demand side and a slow construction recovery on the supply side are likely to support the 2015 growth outlook, with growth projected at 0.5 percent. Lower oil and food prices, a personal income tax cut, and the gradual improvement in the labor market are boosting disposable incomes and private consumption. Although the current account balance improved in early 2015, on the back of transfers from the EU and retained profits, external vulnerabilities remain high as foreign debt reached a ten-year high, led by government borrowing. Fiscal vulnerabilities deepened in 2014 with the deficit at 5.7 percent of GDP and public debt at 86 percent of GDP in March 2015. The economy requires robust structural reforms to secure macro stability, underpin employment and reduce poverty. Croatia has emerged from a six-year recession. According Labor markets improved slightly supported by active to seasonally adjusted data, quarterly growth turned positive labor market policy and employment subsidies. Survey in the last quarter of 2014. In early 2015, real GDP continued data for the first quarter indicate an annual decrease in to grow, reaching an annual rate of 0.5 percent - the highest unemployment and increase in employment, which brought since the last quarter of 2008. High frequency data point to the unemployment rate down to 18.1 percent, 0.6 percent even a stronger recovery in the second quarter. Industrial lower than the first quarter last year. Unemployment production accelerated in H2 2015 leading to a January-June continued declining in the second quarter, by 15.6 percent y- growth of 1.4 percent supported mostly by mining, food, o-y due to higher employment in service and public leather, transport equipment, and fabricated metal production. administration. At the same time, vacancies increased by 27.7 Retail trade in June continued to grow for the eleventh month percent y-o-y. The registered unemployment rate fell to 16.1 in a row, reaching the highs last observed in September 2007 percent in June, the lowest rate in six years. Annualized labor (at 4 percent y-o-y). A reduction in the personal income tax force participation and employment rates (ages 15+) increased rate, a good tourist season (arrivals and nights went up by 11.9 to 52.4 percent and 43.3 percent, respectively, and real wages percent and 14.3 percent by May, respectively) and a grew by 3.2 percent by April 2015, led by private sector wage government-sponsored electric car sale supported retail growth. growth in the first half of 2015 (2.2 percent y-o-y). Following The current account deficit (CAD) narrowed in the first an increase in the number of building permits, the volume of quarter on the back of transfers from the EU and retained construction work rose by 0.6 percent y-o-y in April, for the profits. Solid tourism results (revenues up by 13.8 percent y- second consecutive month, supported by EU funds and FDI. o-y) led to an increasing surplus in services while the goods Deflationary pressures continued in early 2015, deficit deepened, by 7.8 percent y-o-y, due to faster growing supporting private consumption growth. Although imports. On a rolling basis, the current account recorded a consumer prices stagnated in May and June on an annual surplus of 1.1 percent of GDP in the first quarter of 2015. basis, the CPI dropped by 0.3 percent y-o-y in the first half of Exports strengthened further in the second quarter (an increase 2015, mostly due to gas and food price declines. of 9.4 percent y-o-y by May) due to food, clothes products, and machinery and equipment, while import growth slowed. Real GDP, annual growth rates The trade deficit amounted to 15.2 percent of GDP in January- (Percent) May, 1 percentage point down to the same period last year. 1.0 0.5 FDI continued rising in early 2015. Foreign investment 0.0 halted its decline last year, with FDI reaching EUR393 million in the first quarter of 2015, about 40 percent higher than the -0.5 same period last year. According to the structural breakdown, -1.0 % more than 50 percent of total FDI went to financial services -1.5 and nearly 15 percent to real estate. -2.0 -2.5 External debt reached its highest level in the last 10 years in the first quarter – EUR49.3 billion or 112.3 percent of -3.0 GDP. The increase is almost entirely explained by -3.5 2010 2011 2012 2013 2014 2015 government debt (the March bond issue of EUR1.5 billion), which now accounts for a third of total external debt. Source: CBS. Fiscal vulnerabilities continued to deepen. After the fiscal deficit reached 5.7 percent of GDP in 2014, it is estimated to remain above 5 percent of GDP in 2015. The government remove fiscal risks in the health system; (iii) adjust wages to adopted in late April several decisions to respond to the EC productivity and economic reality, including by pursuing request to lower the deficit, as it misses by a wide margin the reform of social benefits and insurance; (iv) reduce Excessive Deficit Procedure (EDP) target. The overall fiscal fragmentation and overlap between the central and local effort adopted for 2015-2016 amounts to 0.63 percent of GDP, authorities, introduce a new model of decentralization and of which 0.18 percent of GDP refers to the withdrawal of rationalize state agencies, and improve SOEs governance; (v) dividends from public enterprises (not necessarily considered reduce para-fiscal fees, remove excessive administrative a sustainable fiscal effort). The government also announced a barriers for service providers, increase efficiency and quality restructuring of public enterprises, whose total debt amounts of the judiciary; and (vi) strengthen the pre-settlement and to 19.7 percent of GDP, of which two-thirds relates to bankruptcy framework and introduce personal bankruptcy railways, roads and highway companies. By July, the procedures. By July, progress has been made on only couple Government accepted only one set of recommendations from of Country-Specific Recommendations, including on the Spending Review, which aimed to rationalize the costs of improvement of the SOEs governance framework (primarily 187 state agencies (saving about HRK1 billion or 0.3 percent of the appointments of management boards), the reduction of of GDP a year). the para-fiscal fees and strengthening of corporate and personal bankruptcy frameworks. By March 2015, the general government deficit already reached 5 percent of GDP. Revenue growth was supported In July 2015, S&P and Fitch revised their outlook on by stronger VAT collection (14.6 percent y-o-y), thanks to the Croatia to negative from stable while affirming 'BB' long- recovery of private consumption and pre-season tourism. A term and 'B' short-term credit ratings. The main reason for decline in the public sector wage bill was completely offset by the outlook revision was the continued worsening of public an increase in social security benefits, while interest payments sector indicators with lackluster structural and fiscal reform continued growing as public debt reached 86 percent of GDP. efforts. Croatia's institutions have so far not been able to In March 2015, ahead of the April redemption of EUR1 effectively respond to the mounting economic challenges, and billion, the government issued a 10-year EUR1.5 billion the upcoming parliamentary elections make any near-term Eurobond with a yield of 3.3 percent. Given its non- reforms unlikely. investment credit rating, Croatia pays a large risk premium Domestic deleveraging continued in 2015. Total loans (350 basis points above Bund) compared to its peers like decreased by 0.4 percent y-o-y in May on the back of Bulgaria (221 basis points) or Poland (73 basis points). New corporate sector deleveraging (3.2 percent), while loans to borrowing followed in July when the government issued a ten- households continued to increase, reaching annual growth of year domestic bond of HRK6 with a yield of 4.69 percent to 1.1 percent. In the first quarter of 2015 non-performing loans cover local bond redemptions and remaining deficit financing stood at the still high level of 17.1 percent. To help indebted for 2015. citizens, the Government adopted a decision to reduce the General government deficit and debt penalty interest rate in June; interest rates were cut from the (Percent of GDP) current 12 percent to 8.14 percent for households, and from 15 100 0 percent (or 12.14 percent) to 10.14 percent for enterprises. The 85.0 amount of maximum allowed interest rates will also be 86.1-1 80 80.6 -2 decreased; for consumer loans from the current to 10.14 -2.7 63.7 69.2 -3 percent and for housing loans from current to 8.14 percent. 60 % of GDP 57.0 This decision follows the earlier freeze of the CHF/HRK % of GDP 48.0 -4 40 exchange rate, which combined will add more pressure on 38.9 -5.4 -5.0 -5 -5.3 -5.7 banks and accelerate the deleveraging by parent banks. -6.0 -6 20 -5.9 -7 After six years of recession, economic activity is expected -7.5 0 -8 to increase by 0.5 percent in 2015. The outlook is subject to 2008 2009 2010 2011 2012 2013 2014 Mar-15 downside risks. Increased financial market volatility is one of Domestic debt Foreign debt Guarantees Total public debt Fiscal deficit (rhs) them, due to high reliance on volatile capital flows (with annual public sector refinancing needs of around 15 percent of Source: MoF, CBS, WB staff calculations. GDP). In addition, a sustained period of low growth in the EU The EC decided not to activate the corrective action will continue to put pressure on export growth. A temporary procedure against Croatia in June 2015. Still, it pointed out one-year peg of the CHF/HRK for loans denominated in Swiss that the "level of ambition" of the Croatian authorities francs, and the unknown final resolution of this issue, weighs "remains below expectations in a number of areas", and has on banks' profitability and lending activity. Fiscal given Croatia six new (same as the old) country-specific consolidation under the EDP also requires faster recommendations to meet in 2015 and 2016: (i) ensure the implementation of structural reforms, which would address permanent correction of the excessive deficit by 2016, fiscal vulnerabilities, underpin private sector growth and EU including by introducing the reformed property tax; (ii) funds absorption as well as decrease unemployment. But this discourage early retirement by increasing penalties and remains challenging in an election year. High frequency data, trend-cycle adjusted series Current account balance (Index) (Percent of GDP) 130 20 125 120 10 115 index, 2011=100 % of GDP 110 0 105 100 -10 95 90 Industry -20 85 Construction 80 -30 Retail trade last obs.: 5/15 (except Constr) 2005 2013 2000 2001 2002 2003 2004 2006 2007 2008 2009 2010 2011 2012 2014 75 Tourism 70 2010/10 2011/10 2012/10 2013/10 2014/10 2010/1 2010/4 2010/7 2011/1 2011/4 2011/7 2012/1 2012/4 2012/7 2013/1 2013/4 2013/7 2014/1 2014/4 2014/7 2015/1 2015/4 Goods Services Income Current transfers Current account balance Source: CBS, WB staff calculations. Source: CNB, CBS, WB staff calculations. Business and consumer confidence Loans, annual growth (Three-member moving averages) (Percent) 150 10 140 8 Domestic credit 130 120 6 Corporate credit 110 4 Households credit %, yoy 100 2 90 80 last obs.: 6/15 0 70 -2 2008 2009 2010 2011 2012 2013 2014 2015 Construction business confidence indicator -4 Industry business confidence indicator last obs.: 5/15 Retail trade business confidence indicator -6 Long-run average = 100 3.11 6.11 9.11 3.12 6.12 9.12 3.13 6.13 9.13 3.14 6.14 9.14 3.15 12.10 12.11 12.12 12.13 12.14 Services business confidence indicator Consumer confidence indicator Economic Sentiment Index (ESI) Source: EC, WB staff calculations. Source: CNB, WB staff calculations. Labor market, administrative data Non-performing loans (Thousands) (Percent) 1500 410 35 Total loans 1450 30 370 Corporate 25 Households % of total loans 1400 thous. thous. 330 20 1350 290 15 1300 last obs.: 6/15 for unempl. 10 1250 250 5 2010/1 2010/4 2010/7 2011/1 2011/4 2011/7 2012/1 2012/4 2012/7 2013/1 2013/4 2013/7 2014/1 2014/4 2014/7 2015/1 2015/4 2010/10 2011/10 2012/10 2013/10 2014/10 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Employment (lhs) Employment_tc (lhs) Unemployment (rhs) Unemployment_tc (rhs) 2009 2010 2011 2012 2013 2014 '15 Source: CBS, WB staff calculations. Source: CNB. Labor market, survey-based data CPI and PPI, annual growth rates (Percent) (Percent) 10 Activity rate Employment rate Unemployment rate - rhs 8 60 20 6 50 15 4 40 2 % % 30 10 % 0 20 -2 5 CPI 10 -4 PPI 0 0 -6 last obs.: 6/15 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 -8 III III III III III III I 2010 IX I 2011 I 2012 I 2013 I 2014 I 2015 V V IX IX XI XI V XI V VII IX V IX V VII VII VII XI VII XI 2011 2012 2013 2014 '15 Source: CBS. Source: CBS. Croatia Selected Indicators* Avg. '00-14 2011 2012 2013 2014 2015 E 2016 F Income and economic growth GDP growth (annual %) 1.7 -0.3 -2.2 -0.9 -0.4 0.5 1.2 GDP per capita growth (annual %) 2.2 2.9 -1.9 -0.6 -0.1 0.8 1.5 GDP per capita (US$) 11128 14540 13235 13608 13490 12715 13200 GDP per capita, PPP (current international $) 17232 20571 21114 21351 21252 21414 21577 Private Consumption growth (annual %) 1.6 0.3 -3.0 -1.2 -0.7 1.5 1.0 Gross Investment ( % of GDP) 23.0 20.3 19.6 19.3 18.6 19.2 19.8 1 Gross Investment - Public ( % of GDP) 4.9 3.5 3.5 3.7 3.6 3.5 3.4 Gross Investment - Private ( % of GDP)1 18.1 16.8 16.1 15.6 15.0 15.7 16.4 Money and Prices Inflation, consumer prices (annual %, end of period)2 2.6 2.1 4.7 0.3 -0.5 0.9 1.7 Inflation, consumer prices (annual %, period average)2 2.7 2.2 3.4 2.2 -0.2 0.2 1.5 M2 ( % of GDP) 67.8 76.4 79.3 82.0 84.9 86.0 85.9 Domestic Credit to the Private Sector ( % of GDP)1 59.7 75.8 71.5 70.9 69.8 69.0 68.0 Nominal Exchange Rate (local currency per USD) 6.2 5.3 5.9 5.7 5.7 6.2 6.2 Real Exchange Rate Index (2010=100) 106.1 101.3 94.3 96.5 106.1 106.1 106.1 Fiscal Revenue (% of GDP) 41.9 41.0 41.7 42.4 42.3 41.9 41.6 Expenditure (% of GDP) 46.4 48.5 47.0 47.7 48.0 46.9 45.6 Interest Payments (% of GDP) 2.2 3.0 3.4 3.5 3.5 3.6 3.6 Non-Interest Expenditure (% of GDP) 44.2 45.4 43.6 44.2 44.5 43.3 42.1 Overall Fiscal Balance (% of GDP) -4.5 -7.5 -5.3 -5.4 -5.7 -5.0 -4.1 Primary Fiscal Balance (% of GDP) -2.3 -4.5 -1.9 -1.9 -2.2 -1.3 -0.5 General Government Debt (% of GDP) 49.6 63.7 69.2 80.6 85.0 88.5 89.6 1 External Public Debt (% of GDP) 23.4 25.4 27.9 33.3 34.6 34.9 34.3 External Accounts Export growth, f.o.b (nominal US$, % yoy) 10.0 13.5 -7.8 6.4 6.8 -2.4 4.2 Import growth, c.i.f (nominal US$, % yoy) 8.4 12.1 -8.8 6.0 3.0 -2.4 4.3 Merchandise exports (% of GDP) 17.1 19.6 19.7 20.5 22.6 23.7 24.0 Merchandise imports (% of GDP) 35.5 33.9 34.1 35.6 37.4 38.8 39.1 Services, net (% of GDP) 14.3 14.1 14.6 15.5 16.9 17.3 17.2 Current account balance (current US$ millions) -1775 -366 -214 448 338 452 341 Current account balance (% of GDP) -3.7 -0.6 -0.4 0.8 0.6 0.8 0.6 Foreign Direct Investment, net inflows (% of GDP)1 3.6 2.7 2.7 2.0 3.0 3.3 3.4 External debt, total (% of GDP)1 81.5 103.7 103.0 105.4 108.2 109.1 107.7 Multilateral debt (% of total external debt)1 6.3 7.3 8.3 8.9 10.4 11.3 11.6 Debt service ratio (% of exports goods and non-factor services)1 42.5 65.6 64.1 51.4 44.2 45.7 45.4 Population, Employment and Poverty Population, total (millions) 4.4 4.3 4.3 4.3 4.2 4.2 4.2 Population Growth (annual %) -0.5 -3.1 -0.3 -0.3 -0.3 -0.3 -0.3 Unemployment Rate1 13.5 13.7 15.9 17.3 17.3 16.9 16.5 Poverty headcount ratio at national poverty line (% of population)1 20.5 20.5 19.5 .. .. .. .. Poverty headcount ratio at US$1.25 a day (PPP) (% of population)1 0.1 .. .. .. .. .. .. Poverty headcount ratio at US$2.00 a day (PPP) (% of population)1 0.1 .. .. .. .. .. .. Inequality - Gini Coefficient1 31.2 .. .. .. .. .. .. Life Expectancy1 75.6 76.8 76.9 77.0 .. .. .. Other GDP (current LCU, billions) 286 333 330 330 329 335 347 GDP (current US$, billions) 49 62 56 58 57 54 56 GDP per capita LCU (real) 71702 76418 74976 74531 74424 74987 76081 Doing Business Rank3 66 .. .. 67 65 .. .. Human Development Index Ranking4 .. 45 47 47 .. .. .. Notes: ".." indicates not available. E = estimate, F = forecast. Data from MFMOD unless otherwise noted. 1/ World Development Indicators Database 2/ World Bank GEM database 3/ This indicator is ranked out of 175 countries in 2007, 178 in 2008, 181 in 2009, and 183 in 2010 and 2011. 4/ The HDI ranking in 2001 is in relation to 175 countries and in 2010 in relation to 169 countries. Methodological enhancements in HDI calculations have resulted in notable improvements in the countries' rankings. Sources: MFMOD Database, World Bank WDI and GEM databases, IMF.