‘Croatia Needs to Play the Cards It Has Been Dealt’

Croatia will join the European Union on July 1, 2013, at a time when both Croatia and the European Union are struggling to revive their economies.

 -After prolonged growth problems over the past few years, it is not surprising that there are optimistic expectations regarding the benefits of EU membership. Although the achievements of previous rounds of EU enlargement seem to be goals that will be difficult to reach, Croatia has several competitive advantages, such as its geographical location, underutilized tourism potential, and well-developed road infrastructure. If Croatia plays the cards it has been dealt well and accelerates reforms, we expect that EU membership will enhance these advantages in the medium term,” explained Alen Kovač, Chief Economist at Erste Bank Croatia.

An intensified influx of capital related to EU membership is considered an important channel for stimulating new growth opportunities through fresh capital, knowledge and experience transfer, and access to new markets. Over the past decade, the inflow of foreign direct investment into Croatia has been significant. However, Croatia has lagged behind other countries in the Central Eastern European region in terms of the structure of these investments, with the service sector dominating while foreign direct investments in the manufacturing sector have remained extremely rare. While this has certainly strengthened the banking sector, significantly less success has been achieved in manufacturing, job creation, and exports. Therefore, the challenge will be to initiate the same growth pattern as in other countries in the region: encouraging foreign direct investments, particularly in productive sectors, and developing more tradable goods that can be exported. Furthermore, accelerating the privatization process, which is highlighted as one of the government’s goals, would ensure a flow of fresh capital, greater efficiency, and knowledge and experience transfer.

Although choosing sectors is difficult, Erste analysts see tourism as a sector that will attract solid interest, given the good tourism results since the beginning of the crisis and still available untapped potential. The transport segment also appears promising, thanks to its favorable geographical position. Furthermore, the well-developed road infrastructure allows for more maneuvering space as EU funds can be directed to other types of infrastructure, particularly railways and ports. The agricultural and food industries remain dependent on economies of scale, while the government’s efforts to increase the utilization of unprocessed agricultural land in state ownership are a step in the right direction. The energy sector is in the spotlight, aiming to replace imports. To stimulate all these sectors, structural reforms are the main task ahead.

-According to international indicators such as the Global Competitiveness Index, the Corruption Perception Index, and the Ease of Doing Business Index, Croatia lags behind other countries in the region. Problems are particularly evident in terms of the size and efficiency of the public sector, rigidity of labor legislation, and weak investor protection. There is no alternative to accelerating reforms, but we see encouraging signals on the ground as policymakers begin to realize that it is necessary to intensify reforms. This is the right moment to improve the business climate, remove barriers to investment, and gain investors’ trust,” emphasizes Alen Kovač.

At the turning point of a new chapter opened by EU membership, another important factor is the fact that Croatia will leave the Central European Free Trade Agreement (CEFTA). This will result in a loss of competitiveness in the CEFTA market, related to trade with Bosnia and Herzegovina and Serbia, due to increased tariffs.

-We expect certain short-term negative effects due to leaving the CEFTA market, but the EU market, with its 500 million people, offers greater potential in the medium term. Additionally, due to EU membership, domestic production will be under competitive pressure due to intensified imports from the EU, which we hope will stimulate increased efficiency, but at the same time will present a challenging operational environment for a large number of companies,” points out Alen Kovač.

The total funds available to Croatia from 2014 to 2020 will amount to €11.7 billion (approximately 25% of the expected gross domestic product in 2013). Contracting and spending these significant funds will certainly be important for Croatia’s medium-term growth potential. However, Croatia’s previous results in drawing funds from IPA funds have often been criticized as insufficient. Combined with the fact that contracting and payments at the beginning of the programming period are usually somewhat slower and accelerate after about a year, it seems that Croatia could expect a significant impact from EU funds only in the medium term. This means that Croatia must strengthen its institutional framework and accelerate structural reforms if it wants to fully realize the benefits of the significant EU funds allocated to it.

After joining the European Union, Croatia could enter the Excessive Deficit Procedure (EDP) as its budget deficit exceeds 3% of GDP, although the movement of public debt in terms of crossing the threshold of 60% of GDP is also alarming. While some believe that entering the excessive deficit procedure could send negative messages, Erste analysts see it more as an opportunity. An implicit call for corrective measures and the implementation of medium-term fiscal consolidation could be perceived as in line with IMF requirements, in that it should support stable fiscal policy and ensure greater commitment to fiscal goals.

However, a special report by Erste Group titled ‘Croatia: A Success Story Despite Difficult Times?’ published today, shows that joining the EU can be a good catalyst for reviving Croatia’s growth potential as EU membership will bring fewer fiscal risks in the future, more economic and political stability, and positive pressures towards reforms.

Furthermore, Croatia will have to meet the requirements of the revised Stability and Growth Pact, in the form of new rules (the so-called six-pack) that lay the groundwork for additional fiscal measures, as well as macroeconomic and supervisory activities, shifting the focus from nominal to structural targets.

-An important foundation within the six regulations package of the EU is the debt reduction rule that requires that excessive debt be reduced by one-twentieth annually, which practically implies the necessary stabilization of public debt that is currently on the rise. Overall, the six regulations package will be a key pillar of fiscal stability in the medium term, resulting in a less risky environment for investors,” concluded Alen Kovač.