44544 vol. 3 Croatia Supplement June 2008 External Environment Uncertain The external environment faced by the EU10 and Croatia remains challenging, with continuing turmoil in international financial markets, surging global commodity prices and inflation, and weaker outlook for economic growth in mature markets. Despite some signs of easing since mid-March, the international financial market turmoil has begun to affect negatively global economic growth. Combined with rising inflation, it is likely that the global environment will remain unsettled and challenging throughout this year and 2009. These unfavorable financial conditions have led many governments and private companies in the EU10 and Croatia to postpone external debt issuance this year or, in some cases, resort to syndicated loans to limit costs. While some of the huge uncertainty that underpinned the financial turmoil may have dissipated since mid-March, financial market conditions have continued to tighten, with negative implications for bank lending and capital flows. Interest rates have been on rise, reflecting in Croatia's cost of financing that is approximately 100 basis points higher than a year ago. Banks in the U.S. and in the Eurozone report ongoing tightening of credit standards, following substantial losses shared roughly equally among the two areas. This has started reflecting somewhat on the availability of easily accessible capital for on-lending through domestic banks in EU10 and Croatia. Figure [1]. Six-month LIBOR, in % Figure [2]. EUROSPREAD in basis points 6.0 350 5.0 300 Croatia Bulgaria 4.0 250 Romania 3.0 200 2.0 150 Libor EUR 100 1.0 Libor USD Libor CHF 50 0.0 06 60r- 6 6 - l-0 06 06- 07 70r- 7 7 l-0 07 07- 08 80r- 8 70 70 7 7 70 7 7 7 7 80 80 8 8 an-J Ma May-0 Ju ep-S 07-l 07-t 80-y Nov an-J Ma May-0 Ju ep-S Nov an-J Ma n- b- May-0 r-0a Ja Fe M r-0pA 70-y n- g-0 p-0 v-0 c-0 n- b- Ma Ju Ju r-0a Au Se Oc No De Ja Fe M r-0pA Ma Source: BBA, Emerging markets database Global food price developments pushed food inflation in the EU10 countries and Croatia and contributed substantially to the overall inflation in the region given the large food share (around 25-30 percent) in an overall consumption basket. By mid-2008, food inflation reached double digits in almost all countries in the region. March and April 2008 recorded the highest annual increases in food prices in both the EU and the euro area since 1996. Outlook for food inflation in the EU10 and Croatia in 2008 remains mixed. Latest data on global food prices seem to point to easing off of food prices but uncertainty remains as to the sustainability of this tendency given the structural factors affecting global supply and demand. Improving the regulation and incentives for energy efficiency initiatives would continue to be an important factor for containing energy prices and would thus limit the effect on food prices. Output Performance Still Strong, Although Slowing Down Output is growing at a slower pace in Croatia and many of the EU10 countries thus far this year and is slowing down substantially in Estonia, Latvia and Lithuania. Some slowdown in growth is welcome, especially given the built-up imbalances in some countries of large current account deficits, high external debt and high and rising inflation. According to the quarterly GDP estimate, Figure [3]. GDP growth rates (% yoy) the Croatian economy grew at a rate of 5.6% in 2007, with a deceleration to 3.7% 16 in the last quarter of the year, primarily 4Q 07 1Q 08 2007 14 due to a weak export performance. The 12 main growth contributor was household 10 consumption that increased by 6.2% y/y, 8 boosted by wage and social transfers' 6 increases. Government consumption grew as 4 well by 3.4% y/y (1.2 p.p. above 2006 growth) driven by 6-percent public sector 2 wage growth and a high increase in other 0 government consumption. Investments BG CZ EE HU LV LT PL RO SK SI HR reported an increase of 6.5% y/y in 2007 versus 10.9% y/y a year ago, while both Source: CSOs. exports and imports posted decelerated growth. In terms of gross value added, the highest output increase in 2007 was seen in hotels and restaurants (9.4% y/y), wholesale and retail trade (7.5% y/y), and financial intermediation (8.2% y/y). High frequency data point to a still strong growth in early 2008. The total volume of Figure [4]. GDP growth rate (in %) and industrial production and construction works relative contribution of demand categories increased robustly. Industrial production (in percentage points) original data, accelerated to 5.3 y/y; mostly on the back of constant prices non-durable consumer goods' production 12 increase by 8.3%. Construction output posted a 9 strong rise of 10.2% in 1Q, up from an annual average growth of 2.4% in 2007. As regards 6 service activities, the retail trade turnover % 3 recovered and positive developments in 0 tourism continued in the same period. -3 The outlook for 2008 suggests a growth -6 slowdown to around 4.5 percent. This mainly 4 4 4 4 5 5 5 5 6 6 6 6 7 7 7 7 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 reflects slower consumption growth and the Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Gross capital formation Personal consumption deceleration of government investment. The Government consumption Net foreign demand GDP CNB's Consumer Confidence Survey results for early 2008 indicate a marked decline in consumer optimism at the beginning of the year. The current consumer confidence indicators began decreasing at the end of 2007 and point to moderate weaknesses in the near term. Labor Market Improved, Wage Pressures on Rise Strong GDP growth has supported robust job creation in most countries in the region in 2007. Robust employment increases, together with strong outward migration and rising inflation, have added to wage and inflation pressures. Growth in unit labor costs (ULC) has been particularly buoyant in the Baltics and Bulgaria, countries that have exhibited one of the fastest increases in inflation in the region, while it has been quite modest in the Czech Republic, Slovakia and Slovenia. Positive labor market trends which prevailed throughout 2007, continued in early 2008. As suggested by the recent Labor Force Survey results (that follows the ILO methodology), unemployment rate stood at 8.2% in the fourth quarter of 2007, while the average unemployment rate for the whole year was 9.6%, one and a half percentage points less than a year before. There are also indications of further decline in youth unemployment, although not in the long-term unemployment. Labor force participation (age 15-64) also increased due to a stronger growth of youth employment. A reduction of unemployment is expected throughout the year towards eight percent at the annual level. On the other hand, a number of unemployed registered with the Croatian Employment Service (CES) stood at 263,357 at the end of May 2008, a decrease of 11.6% y/y. This was due to a reduced inflow into the CES register and an increase in outflow, primarily in employment from the register. The official unemployment rate stood at 13.2% at the end of May, dropping by 1.9 percentage points from a year ago. New jobs were mainly found in manufacturing, trade and tourism sector. Figure [5]. Unemployment rates, % 25 16 CZ HU 16 BG RO HR LV SI 14 20 PL SK 14 LT EE 12 12 15 10 10 8 10 8 6 5 6 4 4 2 0 0 2 05 05 05 05 06 06 06 06 07 07 07 07 08 50 50 50 50 60 60 60 60 70 70 70 70 80 05 05 05 05 06 06 06 06 07 07 07 07 08 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q Source: Eurostat, staff calculations. A wage pressure remains strong, while there has been some moderation of real wages due to an acceleration of inflation. Further pressures can be expected as a result of the recently approved minimum wage law, which set the minimum gross wage to rise to 39% of the average wage in the previous year (equals to HRK 2,747) from July 1, 2008. An increase in the minimum gross wage will affect some 10% of employed people, although particular labor-intensive branches (like textile and leather) will be adjusting their wage scales over a longer period of time. Figure [6]. Real wage growth, yoy, % 25 CZ PL 25 EE LV 25 BG RO LT SI 20 SK HU 20 20 HR 15 15 15 10 10 10 5 5 5 0 0 0 -5 -5 -5 05 05 06 06 06 06 07 07 07 07 05 05 06 06 06 06 07 07 07 07 05 05 06 06 06 06 07 07 07 07 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q Source: CSOs, staff calculations. Inflation on a Hike, Monetary Policy Tightening Surging prices for food and imported energy together with buoyant domestic demand in many countries have continued to support an Figure [7]. Croatia: Inflation, y/y index increase in inflation in early 2008. Increases in food prices contributed most to inflation 113.0 across the region in 2007 and thus far in 111.0 109.0 2008, ranging from nearly half in Bulgaria, 107.0 Romania and Latvia, to one-third in all other 105.0 countries but the Czech Republic (where the 103.0 contribution was one-fourth). The reappraisal 101.0 of credit risk world wide has been translated 99.0 Food prices into increasing costs of borrowing by banks, 97.0 CPI being a potential factor of limiting 95.0 V IX V IX V IX V IX V investment. However, the dynamic credit 2004I 2005I 2006I 2007I 2008I growth to private sector is still being Source: CROSTAT observed in a number of countries, well above the average rate in the euro area. The annual inflation in Croatia stood at 6% in January-May period, with 1.1% m/m growth in May. The marked acceleration of consumer price inflation was attributable to a large extent to supply side shocks, especially rise of industrial food products and energy. The Producer Price Index (PPI) increased to 8.7% y/y in May, following 7.7% y/y increase a month earlier, indicating that inflationary pressures are not easing as yet. All main industrial groupings contributed to the acceleration of overall PPI inflation with the strongest contribution of durable consumer goods and energy. Annual industrial PPI rose by 7.8% in the first five months of 2008. Figure [8]. Appreciation pressures Figure [9]. Interest rates rising, in % continue, 2001=100 105 13 100 12 apreciation 11 95 10 Kuna 9 90 8 FX indexed 7 85 Real,CPI 6 Real, PPI Nominal 5 80 4 04- 5 05 05 06 7 07 07 8 4 5 6 7 r-0a n- 05- 6 06 r-0a n- 06- r-0a n- 07- r-0a 04 40 l-0 40-t 05 50 l-0 50-t 06 60 l-0 60-t 07 70 l-0 70-t 08 80 Dec M Ju Sep- Dec M Ju Sep- Dec M Ju Sep- Dec M an-J Apr- Ju Oc an-J Apr- Ju Oc an-J Apr- Ju Oc an-J Apr- Ju Oc an-J Apr- Source: CNB The average kuna/euro exchange rate depreciated slightly by 0.8 percent in nominal terms in May compared to December 2007, while it has appreciated by 7.1 percent against the US dollar, following dollar's weakening against euro in the international foreign exchange market. In January-May period the central bank held only one foreign exchange interventions in an effort to alleviate appreciation pressures, purchasing from banks a total of EUR 189.1mn at an average exchange rate of HRK/EUR 7.24. The index of the real effective exchange rate appreciated by 2.1% deflated by consumer prices (March 2008 compared with December 2007), indicating a slight weakening of price competitiveness of Croatian economy. Figure [10]. Credit growth developments, Figure [11]. Banks' placements slowing in percent (compared to December 2007) down 5 25 250 Toatal bank loans 4 Loans to enterprises 20 200 Loans to households 3 15 150 % KRH 2 In 10 100 nb 1 In 5 Balance - right 50 0 y/y - left -1 0 0 06 70 -2 04- Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 an-04J un-04J Nov r-05pA 06- y- 07- ep-05S eb-06F Jul- r-08a Dec Ma Oct M Source: CNB The central bank's efforts to reduce the external vulnerability by curbing the credit growth have proven effective in late 2007 and early 2008. Bank placements' growth to non-banking sector slowed down substantially; the end of April bank placements to the non-banking sector increased by 11.6% y/y, largely due to households' credits. Total bank placements to corporate sector continued to slow down, substituted by a diversion to direct borrowing from abroad. Thanks to the combination of monetary, administrative and supervisory measures, aimed at reducing both macroeconomic and financial vulnerabilities, recent data indicate a slowdown in foreign-currency lending (from 71.7 percent in 2006 of total loans to 61.3 percent in March 2008). However, despite some reduction, credit risk remains strong. There is still a large share of FX-denominated loans that are particularly attractive to households due to lower real interest rates, whereby banks shift the exchange rate risk to clients-households, known of non- hedging their exchange-rate risk. External Imbalance Deepening Albeit at a Slower Rate Healthy corrections have begun this year in some of the countries with the largest current account deficits, notably Latvia, Estonia and Bulgaria, after these deficits widened further in 2007. In most EU10 countries current account positions are to continue improving in 2008 and 2009 in line with moderating domestic demand and weakening imports. Notably, in the Baltic countries, where external imbalances have remained alarmingly high, these are to improve substantially on the back of ongoing economic adjustment. The Croatian current account deficit (CAD) Figure [12].CA Balance, % of GDP widened to EUR 3.2bn or 8.6% of GDP in 2007, increasing by 0.7 percentage points 0 of GDP over 2006. The deterioration of -2 foreign trade played a major role in that with foreign trade deficit in goods up by 13.1%. -4 -3.7 Export growth slowed down significantly, from -5.0 17.2% in 2006 to 8.6% in 2007, mainly as a -6 -6.3 result of substantial slowdown in Q4 2007. Net -8 -7.2 FDI with EUR 3.4bn or 9.1% of GDP in 2007, -7.9 -8.6 -8.6 more than offset the CAD. The 34-percent -8.8 -10 increase compared to 2006 is due to Telecom 2001 2002 2003 2004 2005 2006 2007 2008e and Oil Company privatization and Source: CNB, CROSTAT, staff estimate recapitalization of banks. Trade imbalance continued widening in January-April period with imports and exports growing at 8.2% and 15.9% y/y respectively, creating a trade deficit in the amount of EUR 3.8bn. The highest deficit contribution came from capital goods and energy. Further deterioration can be expected by June given further rise in global oil prices as well as other primary commodities. The harmonization of legislative provisions governing the monitoring Figure [13]. External debt developments, in bn EUR of foreign borrowing with the EU 40 requirements, which came into force in early 2008, caused an upward 35 adjustment in the external debt 30 Direct investment balance, increasing it by EUR 0.5bn 25 or from the previously reported 87.7 Banks 20 to 88.9% of GDP in 2007. Gross external debt continued to rise 15 Other sectors albeit at a slower rate in early 2008 10 and stood at EUR 34.4 or 83.7% of 5 projected annual GDP in March 2008. Government 0 This was mainly due to an 2006 2007 Mar-08 acceleration of external borrowing of enterprises and intercompany Source: CNB, staff calculations. lending between mother and domestic banks. The maturity structure of Croatia's external debt remains relatively favorable with short-term debt at 13% of total. Accelerated Fiscal Consolidation Efforts Are Needed to Control Demand Buoyant revenues, reflecting a combination of improved collection, surging inflation and stronger inflows of EU funds, have helped improve fiscal positions this year in the EU10 and Croatia. Output contraction is yet to take its toll on the fiscal positions of the Baltic countries. Some further modest fiscal consolidation is expected in most EU10 countries this year, in line with the EU member states' medium-term fiscal objectives. Addressing considerable risks and challenges will require the conduct of prudent macroeconomic policies, with fiscal authorities avoiding pro-cyclical loosening and generous spending policies. The current conjuncture poses special challenges for fiscal policy. Growth-induced revenue overperformance has improved Croatia's fiscal position. The 2007 outturn was marked by strong revenue growth, which allowed for additional spending as well as for a reduction of fiscal deficit from planned 2.6% to 2.3% of GDP (GFS 1986 methodology). However, taking into account off-budget and quasi-fiscal activities not included in the general government accounts (at 1.8% of GDP), overall fiscal position remains unchanged compared to the 2006 level, while overall fiscal policy stance turned to cyclically neutral. The deficit was financed mostly by domestic borrowing and privatization receipts which amounted to 1.1 percent of GDP. Although the projected general government deficit for 2008 remains at the level of 2007 outturn, i.e. at 2.3% of GDP, a reduction in off-budget and quasi-fiscal activities by 0.6 p.p. of GDP will improve the overall fiscal position in 2008. With the current projected economic slowdown in 2008, fiscal policy may turn to a counter-cyclical path again. Public debt (including state guarantees and the debt of the state development bank HBOR) declined by two percentage points of GDP in 2007, to 47.8 percent of GDP. Foreign public debt continued declining and reached 21.3 percent of GDP (one p.p. of GDP less than a year ago), while total state guarantees accounted for 6.3 percent of GDP. Strengthening of kuna against euro and US dollar statistically decreased the stock of debt by around 0.3% of GDP. Figure [14]. Fiscal developments CGG, in percent of GDP 2006 2007 2008 1. Net lending (+) / borrowing (-) GFS 2001 -1.8 -1.4 -1.6 2. Disposal of non-financial assets 0.5 0.5 0.3 3. Lending minus repayments 0.4 0.4 0.2 4. Disposal of financial assets 0.1 0.1 0.2 5. Balance without capital revenues(1-2-3-4) -2.8 -2.3 -2.3 6. Change in arrears (negative change denotes increase) -0.2 0.1 ... 7. Accrual balance without capital revenues (5+6) -3.0 -2.3 -2.3 8. Pensioners' debt repayment -1.0 -1.2 -0.3 9. HBOR balance (net of budget transfers) -0.2 -0.5 -0.8 10. Overall fiscal position(7+8+9) -4.1 -4.1 -3.4 Note: 2006 and 2007 are outturns, while 2008 is plan. Local Government statistics covers only 53 units. Source: MoF, IMF. Due to November parliamentary elections, fiscal policy in early 2008 was under the temporary financing regime, i.e. limiting spending to one-fourth of 2007 budget. However, revenue overperformance with significant increase in VAT, social contributions and CIT accompanied by a nominal freeze of total expenditures and net lending led to a further reduction of general government debt to 42.9 percent of projected GDP at end-February. The 2008 budget, adopted in March 2008, targeted the general government deficit at 2.3% of GDP. However, a budget revision is expected in July due to: · Revenue growing at 10-percent rate which would lead to some 1% of GDP higher revenue growth by end-year; · Restrain to finance deficit abroad given the turmoil on the international market; · Need to cover health care system arrears in the amount of HRK 1.2bn, 0.39% of GDP; · Plans to alleviate increase of food and energy prices' impact on citizens through HRK 600-700mn, 0.2% of GDP, transfers and subsidies to companies (in the case of electricity, the government will compensate HEP Electricity Company for a freeze of price for all citizens consuming up to 2000 KWh, and gradual increase to 20% which will be only borne by those that consume more than 3000 KWh); · Agreed with social partners' increase of the non-taxable income from HRK 1,600 to 1,800 to partially compensate the negative impact of growing energy prices. Local authorities will be compensated for the reduced revenues by raised share in the personal income tax. · A change of the government finance monitoring methodology to ESA 95 which would reduce the reported deficit by some 0.7% of GDP (without taking into account off- budget and quasi-fiscal activities). Reporting plans also include extracting the HAC - Highway Company from the general government reporting. The IMF in March recommended savings of any revenue overperformance in 2008 and bringing the general government deficit down to 1 percent of GDP or less in 2009, thus aiming for balance by the end of the government's term. Significant frontloaded expenditure-led fiscal adjustment is essential, to address external vulnerabilities and inflation. This would include public sector wage restraint to keep the inflationary pressures under control, well targeted means-tested social benefits to vulnerable citizens to address the food and energy price impact on the living standard, and undertaking faster structural reforms that would raise confidence in successfully concluding EU accession negotiations and reducing vulnerabilities. In particular, the urgency of improving the business environment and judicial governance is crucial.