Since the death of President Franjo Tudjman in December 1999, Croatia has made big steps towards European integration. In October 2001, it signed a Stabilisation and Association Agreement with the EU and in March 2003 it submitted its application for EU membership.
The next major step is expected in June, when the EU is due to decide on opening membership negotiations with the country. The official Croatian goal is to join the EU in 2007, probably together with the other two candidates from south eastern Europe, Bulgaria and Romania.
The second priority of Croatian foreign policy is joining the North Atlantic Treaty Organisation (Nato) even before EU membership. As the admission process to Nato is simpler, this goal may also be reached during the mandate of the current government. It would mark the successful completion of the transformation of an isolated Croatia into a fully-fledged member of European institutions and the Western military alliance in just eight years – quicker than other transition countries of central and eastern Europe.
Integrative path
The process of international integration was started by the previous coalition government led by Ivica Racan, which won power in January 2000 after a landslide victory at the parliamentary elections. The six-party alliance was backed by an electorate that voted for an end to Croatia’s international isolation, the strengthening of its democratic institutions and the introduction of market-based economic reforms.
Despite the uneasy internal political situation, the Racan government made substantial progress which received an overall positive assessment by the EU, allowing the Croatian government to submit a formal EU membership application in 2003.
Despite the Racan government’s high international recognition, as with many other transition countries, electors failed to appreciate the government’s reform efforts and the elections of November 23, 2003 resulted in the opposition parties’ return to power. The new Croatian government was formed in December 2003 and is supported by a centre-right coalition which has a slender one-seat majority in the parliament.
New government
After his appointment as prime minister, Ivo Sanader, the leader of the Croatian Democratic Union (Hrvatska Demokratska Zajednica – HDZ), the strongest party in the new coalition, pledged support for further European integration. He also promised close
co-operation with the International Criminal Tribunal for former Yugoslavia in The Hague (ICTY), a pre-condition for the start of EU accession negotiations this year.
Although the Croatian political scene is fragmented and the co-ordination of different political interests is not an early task, EU accession may become an incentive for the political parties to improve co-operation.
Mr Sanader, who is acknowledged even by his political opponents for his efforts to transform HDZ into a moderate European-style centre-right Christian democratic party, and for distancing himself from HDZ’s hard-liners, won the November elections on a moderate right-wing ticket. In the election campaign, he criticised the outgoing coalition led by the centre-left Social Democratic Party (SDP) for the slow pace of improvements in the living standards of Croatians despitethe dynamic economic growth, and promised to tackle the high level of unemployment.
Passing the budget
Croatia needs to reform the economy further but the government will face an uphill task in the coming months if it wants to go ahead with reforms and address social issues at the same time. The first test of the cabinet will be the approval of the 2004 budget, which the government is due to submit to parliament by the end of this month.
For several years, Croatia has enjoyed rapid economic growth but in the third quarter of 2003 economic expansion started to slow down. After a GDP growth exceeding 5% in the first half of 2003, the yearly growth rate of real GDP decelerated to 3.9% in Q3, according to data from the central bank (Hrvatska narodna banka – HNB), which is still substantially above the EU average.
The main driving force of growth was capital formation, which increased by 17.6%, mainly fuelled by road construction. In 2003, several chunks of highways linking central Croatia to the Adriatic cost were completed, which created better access for holiday destinations – necessary for developing tourism further.
The slowdown in industrial production was even more marked than the general cooling of economy: in October 2003 it only grew by 2.2% year-on-year and in November its growth rate turned negative. An export-led upturn is expected this year, as the economic situation in Croatia’s main export markets, especially Germany, improves.
In 2003, personal consumption also slowed, which was reflected by the slight fall in the import of consumer goods. However, due to increased imports of capital goods and services there was a 11.1% growth in total imports, which grew quicker than exports at 8.3%.
On the domestic front, after a continuous decline over the previous 18 months, unemployment started to increase again, reaching 18.9% in November 2003. Unemployment remains one of the main concerns for the Croatian economy.
Reflecting a successful monetary policy, low inflation remains one of Croatia’s main economic achievements. In 2003, average inflation was just 1.5% and in December 2003 year-on-year RPI stood at 1.8%, down from 2.3% a year before. Supported by favourable external conditions – a strong euro, and low inflation in major economies of the world – year-on-year core inflation remained low at 1.2% in December 2003.
Despite the still relatively rapid economic growth, there was no improvement in the country’s trade balance in 2003. Between January and November, total exports of goods and services stood at $5.7bn while imports amounted to $12.8bn (a coverage of 44.5%).
At the same time, the successful tourism season helped to improve the balance of payments that showed a quarterly surplus of nearly e1.8 bn in the third quarter of the year. According to HNB data, the number of tourist nights spent in Croatia in the first 10 months of 2003 grew by 4.3% year-on-year, reaching 46 million, and the number of tourist arrivals grew even faster, by 6.6%. With expected revenues between $6bn-$7bn, tourism remains the main stabilising factor in Croatia’s external position, helping to keep the current account deficit at the expected level of 5% of GDP.
In the first nine months of 2003, foreign direct investment (FDI) inflows shot up 50.5% year-on-year to $1.18bn and net FDI is expected to cover over 90% of the current account deficit in 2003, compared with just 66% a year before. Annual figures include the $505m booked for the privatisation of 25% of INA, the state-owned oil company.
The central bank has been able to keep the exchange rate of the kuna fairly stable in recent years. In 1998, the average exchange rate was Hrk7.13 to the euro; at the end of 2002, it stood at 7.44 and reached 7.65 on December 31, 2003.
Rationalisation
With the economy slowing down, the government may have to consider fiscal restrictions to keep the budget deficit and increasing foreign debt under control. The first measures taken have been rather encouraging: in January the government decided to postpone the promised cut in VAT by 2 percentage points until January 2005 and, in a move to cut the central government’s administrative expenses, it decreased the number of ministries from 19 to 14.
In their statements, government officials also made it clear that some planned social welfare measures (increase of pensions, longer maternity leave) may be subject to successful cost-cutting in other areas. However, the real test for the government’s decisiveness to carry out a restrictive fiscal policy will be the 2004 budget.
Deepening debt
Due to the rather weak export performance and strong demand for imported goods, Croatia’s foreign debt has been steadily growing since 1994. This prompted monetary restrictions by the central bank in 2003 and further moves may be necessary this year.
Between 1994 and 2002, Croatia’s gross outstanding debt grew from $3bn to $15.4bn, and the country’s gross indebtedness indicators have been worsening (debt to exports ratio grew from 41.6% to 145.9%, the external debt service ratio from 9% to 26 %). On the other hand, gross international reserves rose from $1.4bn to $5.9bn and the import coverage by reserves increased from 2.4 to 5.6 months.
Last year, Croatia’s gross foreign debt grew further, reaching $21.6bn at the end of 2003 (the increase was partially due to the weak dollar). But, given its favourable maturity composition (short-term debt accounts only for 16.9%), analysts do not see any problem in debt service that could endanger the country’s investment-grade rating.
This year, the state is due to meet its $1.25bn in debt obligations, companies have to repay $1.3bn and banks $500m during the year.
In 2003, the main concern of Croatian monetary policy was the limitation of domestic credit growth, which was considered the main reason for the growth of foreign debt. The banks’ rapid expansion in 2001-2002 and, in particular, the rapid acceleration of their loan portfolios prompted the HNB to take steps aimed at curbing the expansion of lending and making the use of foreign funds more expensive.
Controlling growth
To a lesser extent, the HNB was also concerned about the fast growth of several banks, which in some cases was almost 100% a year.
Probably the strictest measure that the HNB has taken was the introduction of a 16% cap for yearly lending growth, a figure over which banks were obliged to purchase low-yield HNB bonds. In addition, the 16% was divided into quarterly limits of 4%, over which the same sanctions were applied.
The “16% rule” was abolished starting from January 1, 2004 but the HNB maintained the restrictions on foreign exchange funding, under which banks must keep 35% of all their foreign exchange (FX) liabilities in liquid (usually low-yield) FX assets, which dramatically increases the final cost of attracted FX funds.
Commercial banks reacted to the HNB’s measures by reducing overall lending growth to a rate close to the required 16%. This slowdown took place in an unequal way, however: while corporate loans grew by about 4-5% in a year, retail lending continued to expand at nearly 25%.
“Credit growth cooled down in the second half of 2003 but we would like to see our banks relying more on domestic sources,” says deputy governor of the central bank Boris Vujcic. “The government also plans more domestic issues, which should boost the relatively underdeveloped Croatian financial market,” he says. He does not expect substantial changes in the HNB’s monetary or exchange rate policy this year, which would cause headaches for the commercial banks.
In the meantime, the ministry of finance is preparing for negotiations with the IMF. As state secretary Martina Dalic emphasises: “Croatia expects a new arrangement with the IMF after the expiry of the previous one in April 2004.”
Ms Dalic expects the 2004 budget to focus on fiscal consolidation and the reduction of the deficit “although it may be early to speak about details”. She believes that some cooling of economic growth may even be helpful because it may help to improve the balance of payments and curb growth of external debt. “To develop exports, Croatia needs more FDI,” she says. “There is an increasing interest from medium-sized companies in Italy, Austria and Hungary which are ready to invest in Croatia.”
