IMF: Croatian economy will grow by 2.4 percent this year

The Croatian economy is expected to grow by 2.4 percent this year, while average inflation will be 7.5 percent, according to a statement from the IMF after its Executive Board concluded consultations regarding Article IV of the IMF’s Articles of Agreement, adding that short-term fiscal policy should support the tightening of monetary policy and not contribute to an increase in aggregate demand.

The IMF has thus revised its earlier forecasts upwards, as in the Mission statement at the end of its visit to Croatia during regular consultations with member countries on May 23, a growth of 2.2 percent for the Croatian economy was projected for this year, and in the April forecasts, it was 1.7 percent.

The IMF Executive Board concluded consultations regarding Article IV of the IMF’s Articles of Agreement with Croatia without formal discussion, according to the IMF statement from Thursday.

The IMF Executive Board emphasizes that Croatia has become the 20th member of the euro area this year, demonstrating that it has made significant progress since joining the EU in 2013, and the introduction of the euro has improved the country’s rating, facilitated access to capital markets, and largely eliminated exchange rate risk.

In 2022, driven by domestic demand and tourism, economic growth was 6.2 percent. The fiscal position improved significantly, recording a small surplus, and public debt decreased significantly to 69 percent of GDP, which is below the level it was at before the pandemic. However, due to a strong rise in energy and food prices, consumer price inflation reached its highest level in several decades by the end of the year, the statement says.

However, this year, weak foreign demand, tightening financing conditions, and continued high global uncertainty are expected to moderate the growth rate to 2.4 percent. Growth is projected to gradually recover towards potential growth rates from 2024.

Reduction of Inflation

According to IMF projections, inflation will decrease to an average of 7.5 percent in 2023 and lower to the ECB’s target inflation rate of 2 percent by the end of 2025. The outlook remains subject to significant uncertainty, the statement emphasizes, adding that the introduction of the euro had a very limited impact on inflation.

These prospects remain subject to significant uncertainty, and the risks to growth are generally balanced. Negative risks include the intensification of the war that Russia is waging in Ukraine, a renewed strong rise in commodity prices and inflation, a stronger global or regional recession, and tighter financing conditions than expected. On the other hand, the introduction of the euro and entry into the Schengen area could provide a stronger boost to tourism, trade, and investment. For inflation, however, upward risks prevail, the IMF statement emphasizes.

Need to abolish energy price caps and tax relief measures

As further emphasized by the IMF Executive Board, short-term fiscal policy should support the tightening of monetary policy and not contribute to an increase in aggregate demand. They note that there is a labor shortage in the labor market, core inflation is still elevated, and the introduction of the euro has mitigated the effects of the ECB’s tightening monetary policy. Therefore, an expansionary fiscal policy creates a risk of stimulating domestic demand and inflation, jeopardizing Croatia’s competitiveness. It is necessary to abolish widespread measures, especially price caps on energy and tax relief, they state.

The most important thing is to continue fiscal consolidation that also favors growth in the medium term, by improving tax policy, reducing the rigidity of consumption, and increasing its efficiency, the statement further says.

They note that given the very rigid budgetary spending in Croatia and the need for further reduction of public debt, any tax reform should preserve revenue sources while also improving the structure of the tax system to reduce distortions and support fairness and growth.

A modern property tax and the alleviation of favorable taxation of short-term rental income would contribute to reducing demand for residential real estate, increasing supply, and encouraging labor force participation. A simplified and transparent public sector pay system that rewards merit and productivity would contribute to improving public services and increasing the efficiency of that sector.

They also note that the increase in healthcare and pension costs caused by an aging population requires renewed efforts to extend working life and decisively address overdue unpaid obligations in the healthcare sector.

In addition, improving monitoring and corporate governance of state-owned enterprises will reduce potential fiscal risks and maximize the contribution of these enterprises to growth. They state that efforts should continue to strengthen the public investment management system, including establishing a strong central coordinating function in the Ministry of Finance.

The fiscal system is currently stable, and the banking system remains profitable, well-capitalized, and highly liquid, the statement emphasizes.

The IMF also states that the continuation of structural reforms is crucial for realizing the full benefits of euro adoption and supporting income convergence. Croatian authorities should continue their commendable and decisive implementation of the National Recovery and Resilience Plan. Priorities include increasing productivity, accelerating the green and digital transition, and finding the best solutions regarding aging and population decline.

The current labor shortage in the labor market presents an opportunity for further labor market reforms. More ambitious reforms are needed, with funds from EU sources, to address relatively low productivity in enterprises and inefficient resource allocation, among other things, the statement notes.