Document of
The World Bank Group
Report No. 106507-HR
INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT
AND INTERNATIONAL FINANCE CORPORATION
AND MULTILATERAL INVESTMENT GUARANTEE AGENCY
PERFORMANCE AND LEARNING REVIEW
OF
THE FY14-17 COUNTRY PARTNERSHIP STRATEGY FOR
THE REPUBLIC OF CROATIA
Croatia Country Office
Central/Southern Europe and Baltics
Europe and Central Asia Region
The International Finance Corporation
Europe and Central Asia
The Multilateral Investment Guarantee Agency
CURRENCY EQUIVALENTS
(Exchange Rate as of June 30, 2016)
Currency Unit = Croatian Kuna (HRK)
US$1.00 = 6.75355 HRK
FISCAL YEAR
January 1 – December 31
ABBREVIATIONS AND ACRONYMS
ASA / Advisory Services and Analytics / LROs / Land Registration OfficesCOs / Cadastral Offices / M&E / Monitoring & Evaluation
CLR / Completion and Learning Review / MOST / Bridge of Independent Lists
CPF / Country Partnership Framework / MSMEs / Micro Small and Mediums Sized Enterprises
CPS / Country Partnership Strategy / NPL / Non-Performing Loan
CSR / EU Country Specific Recommendations / PCG / Partial Credit Guarantee
CHF / Swiss Francs / RF / Results Framework
DH / District Heating / R&D / Research and Development
DLI / Disbursement Linked Indicator / SCD / System Country Diagnostic
DPO / Development Policy Operation / SDP / Social Democratic Party
DPL / Development Policy Loan / SPSMP / Social Protection System Modernization Project
EBRD / European Bank for Reconstruction and Development / SME / Small and Medium Enterprise
EC / European Commission / SOEs / State Owned Enterprises
EDP / Excessive Deficit Procedure (EDP) / M&E / Monitoring and Evaluation
EFIL / Export Finance Intermediation Loan / PforR / Program for Results
ERDPL / Economic Recovery Development Policy Loan / PPP / Public Private Partnership
EU / European Union / RAMP / Revenue Administration Modernization Project (RAMP)
FDI / Foreign Direct Investments / RAS / Reimbursable Advisory Services
GDP / Gross Domestic Product / R&D / Research and Development
GHG / Green House Gas / SCD / Systematic Country Diagnostic
GEF / Global Environment Facility / STP2 / Second Science and Technology Project
HBOR / Croatian Bank for Reconstruction and Development / TA / Technical Assistance
HERA / Croatian Energy Regulating Agency / WBG / World Bank Group
HDZ / Croatian Democratic Union / WPP / Wind Power Plant
HRK / Croatian Kuna
IBRD / International Bank for Reconstruction & Development
ICRR / Implementation Completion and Results Report
ICR / Implementation Completion Report
ICT / Information and Communication Technology
IFC / International Finance Corporation
IOTA / International Organization of Tax Administrators
JPR / Joint Portfolio Review
IBRD / IFC / MIGA
Vice President:
Director:
Regional Manager:
Task Team Leader: / Cyril Muller
Arup Banerji
Andrea Kucey/Carlos Pinerua / Dimitris Tsitsiragos
Tomasz Telma
Thomas Lubeck
George Konda/Magdalena Soljakova / Karin Finkelston (VP & COO)
Dan Biller (Acting)
Gianfilippo Carboni
PERFORMANCE AND LEARNING REVIEW
OF THE COUNTRY PARTNERSHIP STRATEGY
OF THE REPUBLIC OF CROATIA
TABLE OF CONTENTS
I. Introduction 1
II. Main Changes in Country Context 1
III. Summary of Program Implementation 4
IV. Emerging Lessons 12
V. Adjustments to CPS and Future Engagement 13
VI. Risks to CPS Program 15
Annex 1: Updated CPS Results Matrix 17
Annex 2: Matrix of changes to original CPS Results Matrix 21
Annex 3: Matrix summarizing progress towards CPS Objectives 26
I. Introduction
1. The World Bank Group (WBG) endorsement of the Country Partnership Strategy (CPS) in June 2013 coincided with Croatia’s membership as the 28th country to join the European Union. (EU). The program supported Croatia’s efforts to maximize the benefits of EU accession, including access to European Structural and Investment Funds and opportunities to strengthen institutions. The FY14-17 CPS focused squarely on the most pressing challenges to improving the country’s growth prospects: the need for fiscal adjustment and to enhance competitiveness. These themes remain strategically relevant today.
2. At the time of the CPS, the challenges facing the Croatian economy required a strong structural reform agenda and ownership, including to meet EU Country Specific Recommendations (CSR), which proved to be increasingly difficult in the lead up to the political transition. The WBG program supported government efforts first with the ERDPL2, and also through analytical work. Croatia’s economic fundamentals have improved since the approval of the CPS and economic growth returned in 2015 for the first time since the 2008 crisis. The expectation is that growth will continue at a gradual pace, however advances on structural reforms will depend on political developments, including the results of upcoming snap elections, called for by the Croatian Parliament.
3. The WBG program articulated in the CPS is on track to deliver results by the end of the FY14-17 period. The Performance Learning Review (PLR) introduces some modest adjustments to define expected outcomes with greater precision. Given a thorough understanding of development challenges and constraints could help Croatia unleash its full growth potential, the WBG will focus efforts during the remaining year of implementation on the preparation of the Systemic Country Diagnostic (SCD). The SCD will provide an input for informing national policies, lay the foundation for the future Country Partnership Framework (CPF), and allow for a tighter alignment of the WBG program with the Twin Goals.
II. Main Changes in Country Context
4. Accession to the EU implied additional responsibilities that tested the capacity of government to deliver. At the time of CPS delivery, the country was led by the Social Democratic Party (SDP) in a coalition Government with a stable majority. After an active reform effort, with WBG support, the administrative capacity for effective policy design and implementation of complex reforms came under stress from a difficult political environment and the demands of trying to absorb a seven-fold increase in EU funds. While there were notable successes, the Government’s ability to build the consensus needed to accelerate the pace of reforms proved more challenging than expected, and continues to be challenging given political uncertainty.
5. CPS implementation was affected by political developments related to an intense pre-electoral period and change of Government. Following elections in November 2015, further political uncertainty persists. A coalition government was voted in on January 22, 2016, consisting of two main partners, the center-right coalition led by HDZ (Croatian Democratic Union) and MOST, the Bridge of Independent Lists. The Government, led by the Prime Minister, Tihomir Oreskovic, formulated a national reform program that defines key strategic actions for this administration, including to promote macroeconomic stability, improve the business environment and investment climate, and to achieve public sector efficiencies and greater transparency. However, the Parliament was dissolved effective July 15, 2016, following a breakdown in the coalition. A technical government remains in place until a new Government is established after elections due in early September.
6. Economic developments, while not as positive as anticipated in the CPS, reflect an improvement in fundamentals that are underpinning the modest recovery in growth. Post accession Croatia has improved its fiscal position, the current account balance, and maintained a stable financial sector. In 2015, following a six-year recession, the country began its gradual recovery with an annual growth rate of 1.6 percent. Growth was led by external demand, helped by the EU recovery, and revived private consumption boosted by oil and food price declines, income tax changes and an improving labor market.
7. Fiscal vulnerabilities declined in 2015 as a result of concerted efforts in 2014, including on tax collection and the public sector wage bill. The general government deficit in 2015 declined to 3.2 percent of GDP (on an accrual basis) from 5.5 percent in 2014. Public debt rose further to 86.7 percent of GDP. The fiscal situation remains an important concern, and in combination with low potential growth rates has been one force behind the downgrades of the sovereign credit rating to two notches below investment grade status. The European Commission (EC) maintains a close oversight on fiscal outcomes, and is working with the Government to meet Excessive Deficit Procedure (EDP) targets over the medium-term.
8. The financial sector remains stable, despite high Non Performing Loans (NPLs) and an environment of corporate and domestic deleveraging. Lending activity declined by 2.9 percent in 2015 led by accelerated corporate deleveraging in the non-financial sector which reduced domestic borrowing. Households reduced their liabilities to the banking sector as well by 1.5 percent, after the conversion and partial write-offs of Swiss Francs (CHF) loans. In September 2015, the Government adopted a law on the conversion of CHF loans to euro denominated loans, which is estimated to result in bank losses in 2015 and fiscal revenues foregone in 2016 of 1.4[1] and 0.2 percent of GDP, respectively. NPLs at 16.6 percent slightly declined compared to 2014 as the sale of non-performing assets to factoring companies took off. According to Central Bank stress tests, the domestic banking sector is resilient to external shocks. The capital adequacy ratio, at 19.9 percent in September 2015, is well above the regulatory minimum of 10 percent, although the high NPL overhang has an impact on economic growth.
9. The external position has been in surplus since 2012. The current account balance recorded a surplus of 5.2 percent of GDP in 2015. The largest contribution came from a reduced deficit on the income account. Strong tourism sector performance that underpinned a large surplus on services, while EU transfers further strengthened the external position of the country. The trade balance deteriorated despite a strong export growth in pharmaceuticals, ships, car parts, foods and electricity, led by the recovery of EU demand and Croatia’s integration into global supply chains.
Table 1. Macroeconomic Indicators[2]
10. The combination of high labor costs and stagnant productivity is limiting the growth potential of the economy. The increase in labor costs has been largely driven by collective bargaining in a disproportionately large public sector, including public enterprises. While productivity has been largely stagnant since 2006, the unit labor costs increased substantially up until 2009 and culminated in job destruction and higher unemployment rates, in addition to the cyclical factors. Despite moderation since 2010, the average wage level in 2014 is still misaligned with productivity performance and is higher than in its EU peers (like Hungary and Poland, for example). At 16.3 percent in 2015, unemployment remains relatively high. Addressing structural reforms for a well-functioning labor market, as well as public sector, are likely to emerge as a high priority for new administration.
11. Growth and job creation will be the prime determinant for poverty reduction and shared prosperity. Poverty hit a high of close to 10 percent in 2014, as measured at $5 PPP a day. As growth gradually recovers, poverty is expected to decline to 8.4 percent in 2017 and further to 7.7 percent in 2018, based on current growth projections. Labor market improvements have helped reduce poverty, in particular through the service sectors (tourism, construction and professional services). Still labor force participation at 52.7 percent in 2015 is among the lowest in the EU, and presents a strong determinant of low household incomes and greater vulnerability to poverty[3]. Further labor market improvements should improve unemployment rates, which is affecting disproportionately the bottom 40 percent[4].
12. Investment in Croatia continues to contract as a result of structural constraints. Since 2009, the share of domestic investment in GDP dropped from 25 percent to 19 percent in 2015, although it is expected to recover in the next several years underpinned by greater EU fund absorption. While the level of exports has been increasing, Croatia remains a relatively low intensity export economy (48 percent of GDP, compared to 77.8 percent in Slovenia). Before the global crisis, the country relied heavily on domestic consumption and public sector investments. Corporate investment has still not recovered, as companies struggle with high debt levels (despite efforts to deleverage) and the business environment and high labor costs imply a high cost of operation, hurting their competitiveness and capacity to increase their exports in markets with growth potential. State-Owned Enterprises (SOE) tie up a disproportionate part of economic resources and operate at lower productivity and higher cost than private companies, spreading inefficiencies through trade linkages and through a distortion in wage levels. It would seem that there is still significant untapped potential in the private sector, which bears further exploration.
13. The modest economic recovery is expected to continue in 2016-2018 with growth averaging 2.1 percent a year. This estimate is based on assumptions of stronger private consumption, export growth and investment due to improved absorption of EU funds. Private consumption is expected to grow reflecting labor market recovery, increased consumer confidence and a slowdown in deleveraging. Stronger utilization of EU funds, along with recovered FDI in tourism and car supply value chain industries and service sectors (expected at the level of 3 percent of GDP on average per year in 2016-18) will boost investment. Government consumption is projected to remain subdued in light of the need for fiscal consolidation under the Excessive Deficit Procedure (EDP) with the EC. Future growth prospects will be further explored as part of the SCD, which will identify reforms with the potential to increase resilience, reduce vulnerabilities and accelerate the pace of the convergence process.
III. Summary of Program Implementation
14. The proposed CPS program presented a unique opportunity to maximize the benefits of Croatia’s EU membership to develop the country’s economic potential. The two major constraints to development identified in the CPS, notably the need for fiscal consolidation and to stimulate economic growth, remain relevant today.
15. Three thematic areas comprise the strategic pillars and form the basis of the CPS Results Framework (RF): (i) fiscal adjustment through reforms at the sector level; (ii) innovation and trade competitiveness for growth and shared prosperity; and (iii) helping maximize the economic benefits of becoming an EU state.
Pillar I. Fiscal adjustment through reforms at the sector level
16. Activities within this pillar targeted primarily measures to improve efficiency within tax administration, targeting of social assistance programs and rationalization of the health sector. Progress has been made in this pillar, particularly as many outcomes were frontloaded and are now being monitored for sustainability.