EUROPEAN COMMISSION Brussels,7.3.2018 SWD(2018) 209 final COMMISSION STAFF WORKING DOCUMENT Country Report Croatia 2018

Including an In-Depth Review on the prevention and correction of macroeconomic imbalances

Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2018 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2018) 120 final}





Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Summary of the main findings from the Macroeconomic Imbalance Procedure in­depth review 4.Reform priorities 4.1.Public finances* and taxation 4.2.Private sector debt and financial sector* 4.3.Labour market, social policies and education* 4.4. Competitiveness and investment* 4.5. Public governance* Annex A: Overview table Annex B: Macroeconomic Imbalance Procedure scoreboard Annex C: Standard tables References LIST OF Tables Table 2.1:CSR progress Table 3.1:MIP Matrix

Table 4.1.1:Tax wedge comparison with peers Table 4.2.1:Financial soundness indicators, all banks in Croatia Table 4.5.1:Hospital beds by type, per 100 000 inhabitants, 2015 Table B.1:The MIP scoreboard for Croatia (AMR 2018) Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth LIST OF Graphs Graph 1.1: Real GDP growth by demand component Graph 1.2: Current account composition, gross external debt and net international investment position Graph 1.3: Inflation and main components in Croatia and the EU Graph 1.4: Contributions to rate of change in yearly unit labour costs Graph 1.5: Actual and potential output growth 7 Graph 2.1: Level of implementation of 2014-2017 CSRs Graph 4.1.1: General government debt trends Graph 4.1.2: Active government guarantees

Graph 4.1.3: Primary expenditure compared to peers in 2016 Graph 4.1.4: Expenditure by main functions in 2015 compared to peers Graph 4.2.1: Debt composition of non-financial corporations Graph 4.2.2: Contributions to change in total corporate debt-to-GDP ratio Graph 4.2.3: Interest rates on bank loans to corporations Graph 4.2.4: Composition of household lending Graph 4.2.5: Contributions to change in total households debt-to-GDP ratio Graph 4.2.6: Dwellings price developments Graph 4.2.7: Evolution of NPLs and coverage ratio Graph 4.2.8: NPL sales and other NPL flows Graph 4.3.1: Activity, unemployment, long-term unemployment, youth unemployment, NEET and employment rates Graph 4.3.2: Employment rate by educational attainment Graph 4.3.3: Employment change year-on-year Graph 4.3.4: At-risk-of-poverty or social exclusion rate and two of its components (SMD, LWI) Graph 4.3.5: Early childhood education and care Graph 4.4.1: Exports of goods (volumes) in Croatia, EU15 and CEE10, index (2013=100) Graph 4.4.2: Goods' export growth (values) between 2013 and 2016 by markets and product type Graph 4.4.3: Global competitiveness index scores of Croatia and peers Graph 4.4.4: Connectivity index in Croatia and peers Graph 4.5.1: Cohesion Policy funding as an estimated share of public investment, 2015-2017

Graph 4.5.2: Healthcare expenditure Graph 4.5.3: Staff in hospitals, 2015 LIST OF Boxes Box 2.1: Tangible results delivered through EU support to structural change in in Croatia Box 4.1.2: Efficiency of spending in Croatia Box 4.2.3: Crisis and restructuring of Agrokor Box 4.3.4: European Pillar of Social Rights in Croatia Box 4.4.5: The role of Tourism in the Croatian economy Box 4.4.6: Investment challenges and reforms in Croatia Box 4.5.7: Policy Highlight: Developing a Comprehensive Curricular Reform Executive summary The favourable economic environment lends itself to stepping up reform efforts and ensuring sustainable and inclusive growth. Croatia's potential growth remains insufficient to enable faster convergence although projected to increase somewhat over the medium term. As the working age population continues shrinking and labour utilisation remains chronically low, Croatia's prospects of speeding up its economic growth will increasingly depend on the capacity to implement structural reforms. Raising potential growth requires structural reforms that will allow for faster productivity growth, higher participation in the labour market, and a business environment that is more attractive for investment (). As the economy enters its fourth year of recovery, economic growth remains broad-based and robust. Following a sizeable acceleration in 2016, the real GDP growth rate in 2017 is projected to have remained at 3.2 %. Household consumption continues to be the main driver of growth, underpinned by resumed wage growth, steadily increasing employment and high consumer confidence. Investment is recovering, albeit at a slower pace than anticipated. On the external side, strong global demand and further market share gains pushed exports up, but the associated surge in imports of goods is projected to have resulted in net exports slightly detracting from growth in 2017. The recovery is expected to continue in the next two years, with somewhat lower growth rates. Low potential output is preventing the economy from reaching higher growth rates in the longer run. Following several sharp declines in previous years, unemployment is set to continue decreasing at slower rates, on the back of an expected slowdown in outbound migration. Private consumption is expected to remain the driver of growth, as rising wages are projected to offset the effects of the rebound in inflation on disposable income. In 2018 and 2019, investment is expected to intensify, as uncertainties surrounding the restructuring of Agrokor unwind and the use of EU funding improves. Exports are projected to continue performing strongly, but imports are expected to increasingly weigh on the contribution of net exports to growth. With its steady expansion, tourism creates opportunities for employment and growth. However, challenges for policy planning to anticipate and respond to the growing and diversifying tourism demand lay ahead if this sector is to become a key driver of continued economic growth. In all, real GDP is forecast to expand by 2.8 % in 2018 and a further 2.7 % in 2019. Public and private debt ratios continue decreasing, aided by the sustained economic recovery and domestic currency appreciation. With revenues boosted by the recovering economic activity, and spending contained, the general government is keeping a low deficit and the public debt ratio on a steadily declining path. Debt levels in the private sector are also falling, while credit activity is slowly picking up. Corporate debt remains only slightly above prudential levels, but vulnerable to foreign currency shocks. Reflecting declining private and public debt, and as the current account remains in a comfortable surplus, external debt is set to continue reducing. Croatia has made limited progress in addressing the 2017 country-specific recommendations. Fiscal policy, supported by favourable macroeconomic conditions, has ensured a declining debt ratio, but structural measures have not advanced. Legislation needed to reinforce the fiscal framework has not been adopted, while the previously legislated recurrent property tax has been abandoned. Some steps are being taken to rationalise the healthcare system, in particular for hospitals. However, payment arrears in healthcare continue to grow. Measures planned for the social benefits system have been narrowed in scope, while the package of pension system reforms has been further postponed. Active labour market policy measures for low-skilled and long-term unemployed remain largely underutilised, while the education reform is still pending, despite some encouraging steps. Major public administration reforms are largely at a standstill. Measures to improve the business environment have advanced somewhat as regards relieving the administrative burden and reducing parafiscal charges. Some progress has been made in the sale of minority shares in state-owned enterprises and activating state property, while backlogs in the judicial system have marginally reduced. Some measures to address the high level of non-performing loans were put in place. The Croatian Bank for Reconstruction and Development has undergone an Asset Quality Review, the results of which are yet to be unveiled. Regarding progress towards the national targets under the Europe 2020 strategy, Croatia is on track to reaching its targets, or has already done so, in energy efficiency, greenhouse gas emissions, renewables (except in transport), early school leaving and poverty and social exclusion. The target for tertiary education attainment by 2020 does not appear within reach, while the largest distance to target remains in R&D investment.

Croatia faces challenges with regard to a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights. These are related to equal opportunities, access to the labour market and fair working conditions. Economic growth has translated into reducing unemployment, but the employment rate remains comparatively very low. Croatia still faces a high rate of young people not in employment, education or training and low participation in active labour market policy measures. Croatia has a high share of people at-risk-of poverty or social exclusion. The main findings of the in-depth review contained in this report and the related policy challenges are as follows: ·In 2017, the general government debt ratio is projected to have declined further on the back of continued growth and fiscal discipline. During the protracted crisis, the general government debt more than doubled, driven largely by deficits and reclassifications of state-owned enterprises' debt. The decline in the debt ratio from a high of almost 86 % started in 2015 and picked up pace in 2016. It is expected to have shrunk to around 80 % of GDP in 2017 and continue declining in the short term. The decrease has been driven by economic growth but also expenditure restraint. Nevertheless, public debt is still high in comparison with both pre-crisis levels and peer countries. Sustainability risks in the medium term have declined but remain relatively high, especially under some stress scenarios. Furthermore, it is subject to foreign currency risk, as the bulk of it is issued or denominated in foreign currency. Positive developments are the sustained reduction in the cost of debt servicing, the lengthening of maturities achieved in recent years as well as some improvements in debt management. ·Private sector debt reduction progressed, while still heavily exposed to currency risk. The decrease in private debt was driven by intensified economic activity. Furthermore, the continued appreciation of the national currency against the euro reduced the value of outstanding liabilities indexed to or denominated in foreign currency – a positive development that however highlights foreign currency risk. The pace of corporate and household debt reduction slowed down in 2017, following a pickup in net credit flows, which is supporting investment. However, in the corporate sector, debt is concentrated in a few segments and remains high relative to the sectors' financial assets, which may indicate potential solvency risks. ·Indirect credit risk weighs on the well-capitalised and increasingly profitable financial sector. Credit demand is recovering thanks to better macroeconomic conditions and lower interest rates. This, coupled with continued improvement in the quality of banks' assets and profitability, helped turn net credit flows positive in 2017. The relatively fast reduction of the non-performing loans ratio seen in 2016 was halted in 2017, as the underlying declining trend was partially offset by a net inflow of non-performing loans related to Agrokor's defaulted loans. Overall, indirect credit risk remains a source of vulnerability for the banking sector, in particular due to the extensive exposure to foreign currency of its corporate and household clients. ·The labour market continued to improve, but participation remains very low. In 2017, the unemployment rate fell to 11.1 %. Migration outflows and population ageing contributed to the reduction of the working age population, while activity and employment rates for both men and women are very low, partly due to care responsibilities and the availability of multiple pathways to early exit from the labour market. Despite an increase in employment on permanent contracts in 2017, the share of temporary contracts in total employment remains sizable. Youth and long-term unemployment are also on a downward path, but remain high. The social dialogue between the government and the social partners is overall underdeveloped. ·Competitiveness and investment are hindered by a restrictive business environment. The functioning of the product and capital markets is constrained, inhibiting the smooth allocation of resources to the most productive companies and sectors. The suboptimal performance of the research, development and innovation system represents an additional barrier to increasing the competitiveness of Croatian businesses. Liberalisation is progressing slowly as numerous professions and major sectors remain highly regulated. There remain a number of distortions to competition in the legal consultancy and tax advisory. Parafiscal charges and the administrative burden continue to constrain business creation and expansion. The implementation of the anti-corruption strategy suffers delays. Other key structural issues analysed in this report, – which point to particular challenges for Croatia’s economy – are the following: ·The fragmentation of the public administration continues to weigh on efficiency in the provision of public services. Croatia’s marked territorial fragmentation and complex relations across levels of government are not conducive to the efficient utilisation of resources and delivery of public services. Weak administrative capacity hinders the implementation of public policies and a more effective use of European Structural Investment Funds. The wage setting framework lacks consistency across the public administration and public services. While backlogs in courts were reduced largely on the back of a reduced inflow of new cases, measures to improve the efficiency and quality of the justice system remain on the agenda. Some progress has been made in the disposal of minority ownership, and the government's list of companies of strategic and special interest has been further reduced. A more determined progress on the planned privatisation of state-owned enterprises has yet to be seen. ·Although falling, poverty and social exclusion levels are still high. This is particularly the case for the low skilled, the elderly and the disabled. Territorial differences are marked, with very high at-risk-of-poverty rates in some counties. The uneven provision of social services and a fragmented coverage of the population by the social protection system across the territory exacerbate existing disparities in labour market outcomes. The length of working lives is one of the shortest in Europe, impacting negatively on the adequacy of both current and future pensions and creating high risks of poverty in old age. ·Education and health outcomes point to structural weaknesses. Education system performance indicators have stagnated or worsened in most relevant areas, highlighting the need for reform. The recent measures to implement the national strategy for education, science and technology should, if maintained, help address the quality and inclusiveness challenges. Efforts to improve vocational education and training and equip the workforce with the skills needed in the labour market remain insufficient. Participation in adult education remains very low. Health outcomes continue to improve, but remain below the EU average. Some measures aimed at rationalising the hospital system were initiated in 2017. Hospitals, however, remain inadequately financed and overburdened with arrears. 1. Economic situation and outlook GDP growth Croatia's economy continues on its path of recovery from one of the longest and deepest recessions in the EU. In the last three years, the economic recovery has been robust and broad-based, with economic growth on a more solid ground than the credit-driven growth leading up to the 2008 financial crisis. In 2017, domestic demand, and especially private consumption, remained the main engine of growth. Public consumption also contributed to growth following years of negative to neutral contribution. After a long-awaited rebound in 2015, investment picked up further in 2016, but showed signs of slowing down in 2017, under the impact of lower public sector investment and the operational and financial restructuring of the distressed food-processing and retail giant Agrokor (see Box 4.2.1). Exports continued to perform strongly, with goods' exporters gaining further market shares and tourism adding on its record growth achieved the year before. However, the strong internal demand and the relatively high import content of tourism boosted imports further, edging the overall contribution of net exports to GDP growth to the negative side (see Graph 1.1). Overall, in 2017 the real GDP growth rate is projected to have matched the rate of 3.2 % from the previous year. Growth is expected to remain robust and real GDP is projected to finally reach the pre-crisis level in 2019. The economy continues to benefit from favourable external conditions, most notably from the positive trends in global trade and still increasing demand for Croatian exports. As the effects of the recent tax reform fade, private consumption is expected to maintain the momentum thanks to slow but steady employment growth and the pick-up in wage growth. Higher growth rates are projected for investment in 2018 and 2019, driven by the continued favourable financing conditions and increased use of EU funds. In all, the macroeconomic outlook is favourable, but short-run risks remain on the downside, as structural challenges keep weighing on the long-run growth potential, and uncertainties surrounding the outcome of Agrokor’s restructuring linger. The Commission’s winter 2018 forecast sees real GDP growth slowing down to 2.8 % in 2018 and 2.7 % in 2019. Graph 1.1:Real GDP growth by demand component Source: Eurostat. External position Despite the deteriorating trade balance, the current account surplus increases. Declining net exports combined with worsening terms of trade are set to drive a decrease in the overall trade balance of goods and services in 2017. However, the current account balance is projected to have increased to 3.1 % in 2017, in part thanks to the temporary improvement in the primary income balance owing to the profits in the largely foreignowned banking sector having fallen due to Agrokorrelated provisioning. The cyclically adjusted current account surplus of 4.2 % in 2017 was considerably above level of -1.5 % of GDP suggested by fundamentals (). The surplus is projected to remain at around 2 % during the forecast period. The continued current account surplus translates into a further reduction of Croatia's external liabilities. By September 2017, gross external debt had fallen to just above 81 % of GDP 2017, and the NIIP had improved to -62 % of GDP, more than 30 pps above its lowest level attained in the aftermath of the crisis (see Graph 1.2). A continued kuna appreciation contributed to the reduction of the external debt ratio in 2017, but it also reminded of the extent of Croatia's debt exposure to currency shocks. The net external debt ratio is expected to continue declining in line with the continued growth and current account surpluses.

Graph 1.2:Current account composition, gross external debt and net international investment position Source: Eurostat, Croatian National Bank. Inflation and interest rates Wage pressures and higher energy prices set the scene for a modest rebound in inflation. Tightening labour market conditions and wage increases in the public sector are projected to raise the cost of labour in both 2017 and 2018. This, coupled with rising energy prices, pushed inflation up to 1.3 % in 2017, after more than three years of negative or stagnant price dynamics. The headline inflation rate is projected to keep increasing slightly, with core inflation outpacing it and picking up towards the end of 2019. Continued abundant liquidity in the financial system and the decreasing country risk premium are contributing to a further decline in interest rates. Interest rates on all new loans to households and non-financial corporations are decreasing, and most notably on loans for house purchases indexed in euro. These favourable trends in interest rates are expected to continue as the perception of country risk improves thanks to a solid economic outlook and improved public finances. Notably, Croatia's risk premium has reduced strongly, as reflected by the spread between the yield on Croatia's sovereign debt and the German bund dropping to just about 200 basis points at the end of 2017 from 390 in mid2016. However, it remains higher than for most EU countries. Graph 1.3:Inflation and main components in Croatia and the EU Source: Eurostat. Public finances The general government deficit decreases further as revenues surge and expenditures are contained. The general government deficit decreased sharply to 0.9 % of GDP in 2016, from 3.3 % the year before, leading Croatia out of the excessive deficit procedure in 2017. Revenues were boosted by the pick-up in economic activity, especially household consumption, employment and corporate profits. Primary expenditure growth was contained well below nominal GDP growth, while interest expenditure declined as debt was reduced and refinanced at lower interest rates. In spite of the negative budgetary impact of the recent tax rate reductions in 2017, the headline deficit is expected to have reduced further in 2017. Solid growth rates and low deficits in the coming years are set to keep the general government debt ratio on a declining path. The ratio is expected to have declined to below 80 % in 2017, and is set to fall below 75 % by 2019. Private indebtedness The reduction of private debt progressed further, but bank lending to households and corporates has resumed. By mid-2017, consolidated corporate and household debt decreased to roughly 67.8 % and 34.6 % of GDP, respectively – some 15 and 7 pps below the peaks registered in 2010. In 2017, the private debt ratio continued to decrease, mainly on account of GDP growth and, to a lesser extent, valuation effects, as the kuna continued appreciating against the euro, reducing the value of outstanding liabilities indexed to or denominated in foreign currency. In the corporate sector, debt reduction during 2016 was also driven by active deleveraging, with net aggregate credit flows remaining mildly negative. In 2017, however, loans to the non-bank private sector (adjusted for sales and securitisation) from domestic credit institutions increased by 3.4 %, with a sharp increase in new loans contracted in kuna with fixed rates, particularly in the household sector. While debt levels are still high, the decreasing debt servicing burden for both households and corporates is expected to continue supporting new credit. The private debt ratio is therefore set to keep decreasing, but at a slower pace than in recent years. Labour market The labour market continued to improve in 2017, but labour utilisation remains chronically low. Despite moderate improvements in the aftermath of the crisis, both the activity and the employment rates, respectively at 71.7 % and 65.6 % in Q3 2017 (see Graph 4.3.1), were among the lowest in the EU (average 78.2 % and 72.6 % respectively). The decline in the labour force was driven by negative migration flows and population ageing. Also as a result of this decline, the unemployment rate has been on a rapid declining path and is projected to have dropped to around 11.1 % in 2017, from 17.6 % in early 2014. The share of young people who are not in employment, education or training has decreased, but remains very high, as does the youth unemployment rate and the rate of long-term unemployed. With outbound migration pressures expected to ease and stable employment growth, the unemployment rate is projected to fall below 8 % in 2019. In 2017, new hiring on permanent contracts increased, but the share of temporary contracts in total employment remains sizable. Despite low labour utilisation, the tightening labour market has resulted in renewed wage growth. The nominal compensation per employee has decreased every year since 2013, but it is projected to have increased by 2.5 % in 2017. Coupled with modest productivity growth, unit labour cost is projected to have increased by just over 1 % (see Graph 1.4). Wages are expected to continue increasing, following upward pressures from the legislated increases in the public sector, as well as from workforce shortages in several key sectors, such as tourism and construction. Graph 1.4:Contributions to rate of change in yearly unit labour costs Source: Eurostat, European Commission. Social developments The share of people at risk of poverty and social exclusion declined in 2016, but remains high. Risks of poverty and social exclusion (AROPE) are still high in Croatia, particularly for some vulnerable groups such as the disabled and the elderly (see Section 4.3). Croatia registers high shares of population living in severe material deprivation and in households with very low work intensity, exceeding the EU average by 5.0 and 3.2 pps, respectively. The share of people at risk of poverty (AROP) at 19.5 % is above the EU average and exceeds most of the peer countries (income data from 2015). Regional differences are particularly marked, with the AROP rate exceeding 40 % in some counties. Inequality of income is close to the EU average, but risks of poverty and social exclusion remain particularly high among the low skilled. In 2016, the richest 20 % of Croatian households had five times as much income as the poorest 20 %, a ratio just below the EU average (2015 data). The distribution of market income was slightly less unequal than the EU average, while the impact of social transfers on poverty reduction was below EU average in 2016. The concentration of the risk of poverty and social exclusion among the low skilled, often living in rural areas, poses crucial challenges and weighs on the capacity of the country to reduce inequalities (see section 4.3.2). Potential growth Croatia is currently growing well above its estimated potential. The negative output gap is projected to have closed in 2017, and forecast to turn positive in 2018. The solid pick-up in investment is adding to potential growth, but the utilisation of labour input and the contribution of total factor productivity remain low, especially for a catching-up economy. Negative migration flows and population aging, in the context of one of the lowest activity rates in the EU weigh on the size of the working age population, with negative impact on the long-term prospects for employment growth. In the absence of policy measures capable of boosting the participation rate, the shrinking labour force is set to continue detracting from the growth potential (see Graph 1.5). Graph 1.5:Actual and potential output growth Source: European Commission, DG ECFIN.





Table 1.1: Key economic and financial indicators - Croatia (1) NIIP excluding direct investment and portfolio equity shares .

(2) Domestic banking groups and stand-alone banks, EU and non-EU foreign-controlled subsidiaries and EU and non-EU foreign-controlled branches. Source: Eurostat and ECB as of 30 Jan 2018, where available; European Commission for forecast figures (Winter forecast 2018 for real GDP and HICP, Autumn forecast 2017 otherwise) 2. Progress with country-specific recommendations Progress with the implementation of the recommendations addressed to Croatia in 2017 () has to be seen in a longer term perspective since the introduction of the European Semester in 2014. Looking at the multi-annual assessment of the implementation of the CSRs since these were first adopted, almost half of all the CSRs addressed to Croatia have recorded at least 'some progress'. The rest recorded 'limited' or 'no progress' (see Graph 2.1). Most progress has been seen in the areas of labour market reform and fiscal policy. Graph 2.1:Level of implementation of 2014-2017 CSRs Source: European Commission. Croatia has secured a timely and durable correction of its excessive general government deficit. In 2016, the general government headline deficit decreased markedly to 0.9% of GDP from 3.3% in 2015. This sharp reduction was driven by the economic recovery, but also by expenditure containment. The decrease in the headline deficit combined with GDP growth has resulted in a decrease in the debt ratio, which is expected to continue. Croatia exited the Excessive Deficit Procedure in June 2017. Over the past years, Croatia has taken measures to reform the labour market, but the challenge of low labour participation has not been addressed. Two successive reforms, implemented in 2013 and 2014, enhanced the flexibility of the labour market. In particular, they facilitated the use of fixed-term contracts and flexible types of work (distance work, part-time work, seasonal work and agency work), and simplified in various ways the procedures for terminating employment contracts. The challenge of low labour utilisation however has still not received an adequate response, as measures encouraging longer working lives and a streamlining of pension provisions have not yet been carried out. In 2015, the assessment of disability claims was harmonised and moved to a new Single Expert Evaluation Body. Steps have been taken to improve the judiciary system, the business environment, and the resilience of the financial sector. Insolvency procedures have been thoroughly revised, and the reformed judicial map has improved the efficiency of the system. There has been a reduction of backlogs in the judiciary, however challenges remain. Some parafiscal charges and the administrative burden for businesses have been reduced. In 2014, the comprehensive portfolio screening of the banking sector confirmed its robustness, and some identified weaknesses have been addressed. The share of non-performing loans remains relatively high, but they are well provisioned, and their sale has accelerated lately. The Croatian Bank for Reconstruction and Development (HBOR) has undergone an asset quality review. Reforms of healthcare, state-owned enterprises and EU funds implementation have progressed slowly. The healthcare system continues to generate payment arrears. However, the authorities have taken initial steps towards the long-planned functional integration of hospitals. The management of state assets was transferred to a newly established ministry and their sale has advanced, but the announced improvement of corporate governance in state-owned enterprises has encountered delays. The implementation of projects co-funded from EU funds has improved over the past years, but remains hindered by limited administrative capacity and strategic planning.

Croatia has made limited () progress in addressing the 2017 country-specific recommendations (see Table 2.1). The unfolding of the Agrokor crisis in 2017 protracted a period of reform standstill during which Croatia undertook limited policy action. The introduction of the recurrent property tax, due in January 2018, has been postponed indefinitely. The reform agenda in the area of social protection has been narrowed in scope. The planned reforms in areas such as fiscal framework, pension system, public administration and public sector wages have been largely delayed. European Structural and Investment Funds (ESI Funds) are pivotal in addressing key challenges to inclusive growth and convergence in Croatia. This is achieved by supporting the reduction of administrative procedures for businesses, reinforcing capacities in the research and business sectors and improving cooperation between enterprises and public research institution. ESI Funds are also instrumental in addressing challenges related to employment and social policies and via investments in infrastructure which help increase productivity and improve the access to healthcare for vulnerable groups and people living in deprived areas. Member States can request from the Commission technical support to prepare, design, and implement growth-enhancing structural reforms. The Structural Reform Support Service (SRSS) provides, in cooperation with the relevant Commission services, tailor-made technical support, which does not require co-financing and is provided at a Member State's request. The support addresses priorities identified in the context of the EU economic governance process (i.e., implementation of country-specific recommendations), but the scope of the SRSS support is wider as it can also cover reforms linked to other Commission priorities, or reforms undertaken at the initiative of Member States. Croatia has requested technical support from the SRSS to help implement reforms in various areas, such as: public administration and justice, growth and the business environment, healthcare, education, and the financial sector. In particular, the SRSS provides support for the implementation of curriculum reform; for measures aimed at improving adult education; for measures strengthening the governance of state-owned enterprises and monitoring of their restructuring plans; and for streamlined and increased transparency of social policies. Table 2.1:CSR progress Source: European Commission.

Box 2.1: Tangible results delivered through EU support to structural change in Croatia Croatia is a beneficiary of significant European Structural and Investment Funds (ESI Funds) and can receive up to EUR 10.73 billion until 2020. This represents around 3 % of GDP annually over the period 2014-2018 and 80 % of public investment ( I ). By end-2017, an estimated EUR 4.2 billion (39 % of the total) was allocated to projects on the ground. This has paved the way for 734 new full-time equivalent employments having been created in the supported enterprises; supporting sustainable tourism and adding more than 314 000 visits per year of the cultural and natural heritage and attractions; increasing capacity of childcare and education for an additional 6 000 persons in the future. Out of the ERDF financing, approximately EUR 330 million will be delivered via financial instruments, which is a novelty compared to the 2007-2013 period, where financial instruments were not used. ESI Funds help address structural policy challenges and implement country-specific recommendations. Actions cover, among others, a shift to a digital economy and e-systems, aimed at reducing the burden on businesses by making administrative procedures more efficient and effective. Support is provided to improve the effectiveness of the justice system. Investments in infrastructure (namely rail, road, broadband, energy and environment) are aimed at reducing regional disparities, promoting growth and increasing productivity. ESI Funds address challenges related to employment and social policies. The Action Plan for the Implementation of the Public Administration Development Strategy 2017-2020 defines actions on the strategic, legal, organisational and procedural level to develop quality management systems, rationalise administrative procedures, and implement human resources policies that foster skill development at all levels of public administration. Various steps have been undertaken already as a precondition for ESI Funds support. A Smart Specialisation Strategy for research and innovation was developed with a view of building R&I capacities in research and business sectors and improving cooperation between enterprises and public research institutions. The comprehensive Transport Strategy adopted in August 2017 enables streamlining of projects in all modes of transport by defining the measures and setting the priorities on supranational and national level. The Sustainable Urban Mobility Plans at the level of functional regions focus on public transport, low/zero emission modes and will be accompanied by complementary mobility management policies. To ensure a more sustainable use of water resources, the River Basin Management Plan for Croatia has been adopted. In the health sector, specific actions are directed towards improving the access to healthcare in deprived areas and for vulnerable groups; supporting education of medical personnel in primary healthcare; and promoting specialisation programmes and the development of analytical tools in health management. Croatia is advancing in the take up of the European Fund for Strategic Investments (EFSI). As of December 2017, the overall financing volume of operations approved under the EFSI amounted to EUR 187 million, which is expected to trigger total private and public investments of EUR 745 million. More specifically, 5 projects have been approved so far under the Infrastructure and Innovation Window (including 2 multi-country projects), amounting to EUR 120 million in EIB financing under the EFSI. This is expected to trigger nearly EUR 494 million in investments. Under the SME Window, 5 agreements with financial intermediaries have been approved so far. The European Investment Fund financing enabled by the EFSI amounts to EUR 67 million, which is expected to mobilise more than EUR 251 million in total investment. Close to 800 smaller companies or start-ups will benefit from this support. The energy sector ranks first in terms of operations and volume approved, closely followed by SMEs. Funding under Horizon 2020, the Connecting Europe Facility and other directly managed EU funds is additional to the ESI Funds. By end-2017, Croatia has signed agreements for EUR 424 million for projects under the Connecting Europe Facility. https://cohesiondata.ec.europa.eu/countries/HR 3. Summary of the main findings from the Macroeconomic Imbalance Procedure in­depth review The in-depth review for the Croatian economy is presented in this report. In spring 2017, Croatia was identified as having excessive macroeconomic imbalances, in particular relating to the high levels of external and domestic debt, both largely denominated in foreign currency, in a context of low potential output growth. The 2018 Alert Mechanism Report (European Commission, 2017b) concluded that a new in-depth review should be undertaken for Croatia to assess developments relating to identified imbalances. Analyses relevant for the in-depth review can be found in section 4.1 for government debt, section 4.2 for private sector debt and the financial sector, section 4.3 for the labour market, section 4.4 for business environment and investment, and section 4.5 for public sector governance (). Imbalances and their gravity Government debt remains high. The debt ratio peaked at 85.8 % in 2014, driven by large government deficits and the materialisation of contingent liabilities in SOEs. It is expected to have declined to below 80 % of GDP in 2017, thanks to robust nominal growth and a declining general government deficit. Furthermore, the kuna appreciation decreased the value of the large portion of debt denominated in foreign currency. Sustainability risks for Croatia's public finances remain high in the medium term largely on account of the still high stock of debt. The fact that a large portion of the debt is denominated in foreign currency is also a source of risk. The private debt-to-GDP ratio keeps reducing, but exposure to foreign currency and over-leverage of corporations are sources of risk. In the second quarter of 2017, consolidated corporate and household debt had decreased to 67.8 % and 34.6 % of GDP, respectively – some 15 and 7 pps below the peak registered in 2010. By mid-2017, private sector debt was close to or below the prudential country-specific threshold and only slightly above the level suggested by fundamentals, indicating that Croatia still faces limited deleveraging needs (see Section 4.2). Although their level of debt no longer appears exceedingly high, households and non-financial corporations are still exposed to foreign currency risk. Furthermore, in non-financial corporations, debt is high relative to gross financial assets or equity, signalling potential solvency risks for the corporate sector. Finally, a high stock of non-performing loans weighs on the private sector, with a particularly high share of such loans in construction and realestate activities, but also in wholesale and retail trade and manufacturing. Continued current account surpluses are translating into a fast reduction of Croatia's net external liabilities. Thanks to a continued strong performance of exports, the current account stood at 2.5% of GDP in 2016. It increased further to 3.8 % of GDP in the third quarter of 2017, mainly due to the improvement in the income balance. The NIIP improved to -70 % of GDP in 2016 and declined further to -62.1 % by the third quarter of 2017, 36.5 pps above its record low from third quarter of 2011. In the third quarter of 2017, it declined further to 61.8% of GDP. Despite these notable improvements, the NIIP remains very negative. In particular, in 2016, the NIIP was still below its fundamental level and prudential threshold (). However, the composition of Croatia's external liabilities in terms of asset type – in particular, the high share of FDI and portfolio investment in equity – mitigates the vulnerability risks associated to the high level of the NIIP. Low labour utilisation and slow productivity growth weigh on Croatia's potential output and adjustment capacity. Despite moderate improvements, in Q3 2017 both the activity rate (71.7 %) and the employment rate (65.6 %) were among the lowest in the EU, pointing to chronically low labour utilisation. Productivity growth remains low compared to the EU economies of Central and Eastern Europe. Total factor productivity (TFP) contributed negatively to potential growth in the crisis period, and continues to be relatively low. A strong presence of state-owned enterprises hinders a more efficient allocation of resources throughout the economy (see Section 4.5). Weak administrative capacity in the public sector as well as a burdensome business environment (see Section 4.4) weighs on productivity developments and on the economy's overall adjustment capacity. Evolution, prospects, and policy responses The debt ratio is expected to continue decreasing. The primary balance is expected to remain in surplus as the nominal GDP growth-interest rate differential, having turned positive, increases further, also owing to the refinancing of maturing debt at lower interest rates. Recent improvements to debt management could be conducive to an improved fiscal risk management. In addition, a significant portion of the debt previously financed through bank loans was refinanced by a bond, reducing and fixing the interest rate, extending the maturity and enabling better management. The private debt ratio is set to keep decreasing, though at a slower pace than in recent years as new credit started to grow. During 2016, private debt reduction was mainly driven by real GDP growth and valuation effects, since the appreciation of the kuna against the euro reduced the value of outstanding liabilities indexed to or denominated in foreign currency. In the household sector, debt decreased notably due to a large number of write-offs following the statutory conversion of CHF-denominated loans into EUR-denominated loans at the end of 2015. In 2017, the slight rebound in inflation also supported debt reduction, whereas credit flows turning slightly positive worked in the opposite direction, slowing down the debt reduction pace. In 2017, the growth rate of loans to the non-bank private sector (adjusted for sales and securitisation) from domestic credit institutions increased to 3.4 %. The strongest impetus to credit growth in the non-financial corporate sector came from the increase in investment loans and working capital loans, while in the households sector it came from non-housing loans. The banking sector remains well capitalised overall and banks' profitability has been increasing since 2016. Vulnerabilities are linked to the high exposure of corporations and households to foreign currency risk and, to some extent, interest rate risk. Maturity mismatches between assets and liabilities in the banking sector are also emerging, particularly in the increasing segment of kuna-denominated credit. Risks related to this mismatch are limited by the fact that, in the current low-interest rate environment, transaction deposits are increasingly fed with long-run savings. Bank asset quality has continued to improve, but the NPL ratio remains high, especially in the construction and real estate segment. By June 2017, the total stock of NPLs declined to 11.7 % (from a record high of 14.2 % in 2014) despite the inflow of loans classified as non-performing in the aftermath of the Agrokor crisis earlier in the year. The impact of the Agrokor crisis on the Croatian economy has been limited so far, but related risks remain. Despite the fact that most of the Agrokor Group impairments have already been incurred in the first half of 2017, risks remain as the restructuring of Agrokor's may affect profitability during the rest of 2017 through greater provisioning in 2017 and possibly 2018. While the activation of measures on extraordinary administration in systematically important companies () contained the risk of a disorderly restructuring, the outcome of Agrokor's restructuring, in particular if the settlement is not reached, poses a significant downside risk to economic activity and the banking sector, in particular as financial losses and possible operational disruptions in the group and its supply chain may still materialize. Croatia's current account surplus is above the norm suggested by the country's fundamentals and the NIIP-reducing benchmark. Continued current account surpluses are underpinned by the strong performance in exports, with exporters gaining further market shares and tourism expanding. In 2016, the current account balance exceeded the level suggested by fundamentals – that is, the current account norm, estimated at a deficit of around 1.5% of GDP. According to the Commission 2017 autumn forecast, the current account surplus is projected to remain at around 2 % over the forecast horizon. This is above the level needed over the medium term to bring the NIIP up to more sustainable levels – e.g. the levels suggested by the prudential and fundamentals-based benchmarks, even under pessimistic scenarios for nominal GDP growth. The country's net international investment position is set to further improve. Croatia's economy is still growing well above its estimated potential growth rate. The output gap is projected to have closed in 2017 and turn positive in 2018. A strong pick-up in investment, somewhat delayed by the temporary decline in public sector investments and by the Agrokor crisis during 2017, is expected to support the growth potential. However, negative migration flows and population ageing restrain growth of the labour force (see section 4.3). After having attained a record high of 17.6 % in mid-2013, the unemployment rate is estimated to have contracted to around 11 % in 2017. It is expected to fall to pre-crisis levels by the end of 2019, aided by modest employment creation and labour force shrinking. Croatia continues to score poorly on several measures of goods and service market efficiency, and total factor productivity growth remains subdued (see Sections 4.4 and 4.5). Overall assessment The unwinding of debt-related imbalances is supported by a solid recovery, however vulnerabilities remain. Both public and private debt ratios to GDP keep reducing, but still represent sources of vulnerability for the economy. Despite significant improvements, public debt weighs on the country's credit rating and risk premium, and the related debt servicing costs weigh on the budget. Despite significant decreases, the remaining private deleveraging needs hinder the recovery of credit flows and a more substantial pick-up in investment. A large share of both public and private debt remains denominated in foreign currency, which implies exchange rate risks. The unemployment rate has reduced sharply, but remains high, while labour market participation lags significantly behind the EU average. In the long run, low potential growth hinders the resolution of stock-related imbalances. Economic growth is projected to be robust over the forecast horizon. However, for a lasting adjustment, economic growth will need to remain sustained for a long period. This underlines the challenges that the persistently low labour utilisation and subdued productivity growth represent for the economy's potential growth. Policy action has not yet contributed to boost the long-run growth potential and the economy's overall adjustment capacity. In the absence of effective policy measures to boost the participation rate, low labour utilisation is set to keep weighing on potential growth in the long run. Policy action to improve the business environment and modernise public sector governance, in support of TFP growth, have been largely delayed. Structural reforms are crucial to ensuring that Croatia can fully grasp the benefit of greater monetary and financial stability, while furthering the process of real economic convergence. Table 3.1:MIP Matrix (Continued on the next page)

Table (continued) Source: European Commission. 4. Reform priorities 4.1. Public finances* and taxation Croatia's deficit decreased markedly and the debt ratio was put on a declining path. In June 2017, the Council decided to abrogate the excessive deficit procedure for Croatia (), after the general government deficit reached 0.9 % of GDP in 2016, well below the 3 % Treaty threshold. The improvement was largely driven by economic growth supporting tax revenue and restraint of expenditure growth. The lower deficit contributed to the decrease in the debt ratio from 85.4 % in 2015 to 82.7 % in 2016. Nominal GDP growth and the appreciation of the kuna (which reduced the value of the large portion of debt in foreign currency) also contributed to the reduction of the debt-to-GDP ratio. In spite of the continued decrease in 2017 (to below 80 %), the debt ratio remains high, especially compared to peers (). It is expected to continue decreasing as the primary balance remains in surplus and the nominal GDP growth-interest rate differential grows having turned positive, also owing to the refinancing of debt at lower interest rates. Graph 4.1.1:General government debt trends Source: Eurostat. Fiscal policy aims to turn the general government deficit into a surplus in the medium term. The 2018 budget, adopted in November 2017, is consistent with the policy direction in the previous two years and the 2017 convergence programme. In particular, the general government balance was planned at 0.5 % of GDP in 2018, before turning to a balanced budget in 2019 and a surplus of 0.8% of GDP in 2020. These targets seem within reach, also in light of the prudent projections for revenue growth in the budget and the fact that the deficit reductions achieved in 2016 and 2017 provide a good basis for further improvements. Based on the latest available data, the 2017 deficit is expected to turn out significantly lower than forecasted. Risks for public finances arise in the form of healthcare arrears (see Section 4.5), pending legal disputes (), guarantees and the impact of the Agrokor crisis. In particular, after slightly decreasing in the aftermath of the crisis, the level of guarantees issued by the government, mainly on the debt of SOEs, has been rising recently. Agrokor-related fiscal risks include HBOR's stock of outstanding loans issued to companies within Agrokor (ca. 0.15 % of GDP) as well as possible negative effects on tax revenue from creditors and suppliers to the Agrokor group. Refinancing risks appear low in the short term. The government financing needs were met without difficulty in 2017, also thanks to ample liquidity in the banking sector and low and declining interest rates. Yields on government securities have continued to fall in 2017, significantly lowering the cost of refinancing maturing debt. Overall, short-term fiscal risks stemming from the fiscal and broader macro-financial conditions in Croatia have continued to decrease, thanks to the improving state of the public finances as well as GDP growth and deleveraging in the private sector, and appear low ( ). The key risk remains the depreciation of the kuna, since 70 % of public debt is denominated in foreign currency, mainly euros. Graph 4.1.2:Active government guarantees Source: Croatian National Bank. Fiscal sustainability risks remain low in the long term and declined somewhat in the medium term. Assessed on the basis of the autumn 2017 forecast, fiscal risks in the medium term declined since spring 2017, but remain high overall. In particular, the improved budgetary position implies that the size of fiscal adjustment in primary structural terms required to reduce the debt ratio to the 60 % Treaty reference value by 2032 has declined. Still, a sensitivity analysis of the public debt trajectory points to high sustainability risks in the medium term under a scenario which maintains the historic structural primary balance through 2028. It should nevertheless be noted that a 2017 outturn for the deficit and debt ratio better than expected and forecasted in autumn 2017 would further improve the fiscal sustainability risks in the medium term. In the long term, Croatia continues to face low fiscal risks (), largely related to the projected decrease in the spending requirements on pensions which is offset only partially by increased spending requirements on health. The improving country risk was reflected in the first upgrade of Croatia's rating since 2004 (), bringing it to a notch below investment grade. As Croatia's deficit decreases, improving the quality of expenditure can help maintain or improve the quality of services provided. The focus of fiscal policy in recent years has been on decreasing the deficit in line with the requirements of the Stability and Growth Pact. This has been instrumental in restraining the build-up of public debt and subsequently putting the debt ratio on a declining path. Nevertheless, government expenditure in proportion to GDP remains higher compared to peer countries (see Graph 4.1.3), in line with the observed strong influence of the state in the economy. Graph 4.1.3:Primary expenditure compared to peers in 2016 Source: Eurostat. High spending in public administration and low spending in transport, education and R&D stands out for Croatia. In most categories, Croatia's expenditure ratio is in line with that of its peers. Social protection spending is slightly below the average in spite of the comparatively more severe economic situation in recent years. Even when the cost of debt servicing is excluded, Croatia spends considerably above average on general public services, which is mostly related to the cost of public administration at all levels of government. This confirms the conclusions on the analysis of territorial fragmentation in the 2017 Country report, which noted that in local units the administrative functions absorb more than one third of current expenditure, and in some cases the financing of the administration itself takes up to half of the units’ budgets. At the same time, spending is relatively low in Transport, as well as in Education and R&D spending – two areas that are crucial for sustainable growth. Trends indicate that, as a share of total, spending on Transport and Education has decreased in the period 2008-2015, while spending on Health has stagnated. Meanwhile, spending on economic affairs and recreation, culture and religion have been rising. Graph 4.1.4:Expenditure by main functions in 2015 compared to peers Source: Eurostat. The estimated efficiency of spending is low in many areas. In order to assess the quality of public expenditure, a review of its composition has to be complemented by an analysis of its efficiency. The focus on efficiency allows reconciling the goal of sustainable public finances with the continued provision of adequate levels of public services to citizens. Measuring efficiency of public expenditures is a complex task. It crucially requires identifying the goals or outcomes that the public sector aims to achieve in each spending area examined. Public expenditures may fulfil various objectives, such as fairness and redistribution, macroeconomic stabilisation, the promotion of employment and growth. Box 4.1.1 presents the results of the analysis of expenditure efficiency in eight areas: police services, law courts, transport, health, education, research & innovation, social protection and social protection of the elderly. After defining the objectives in terms of output indicators for each expenditure area, it assesses the efficiency with which such expenditure is translated into the set outputs, using the best performing country in the sample as the benchmark. Overall, the analysis suggests there is scope for considerably improving the efficiency of spending in most areas, Social protection and Education being among those in which socioeconomic benefits could be highest. Fiscal-structural issues The long overdue adoption of new Fiscal Responsibility and Budget acts has again been delayed. The national budgetary framework remains underdeveloped. The transparency of fiscal policy suffers from the non-systematic use of sensitivity analyses in budgetary planning and a lack of methodological publications and ex-post evaluations of the official forecasts. The design of the national numerical fiscal rule remains flawed, as no consequences are defined for non-compliance. The domestic medium-term budgetary framework is only indicative for annual fiscal planning and the role of the Fiscal Policy Commission remains weak. Croatia has initiated the ratification of the Treaty on Stability, Coordination and Governance. In the context of Croatia's announced intention to introduce the Euro, in January 2018 the Parliament adopted legislation whereby Croatia became a signatory to the Treaty on Stability, Coordination and Governance. Croatia is exercising its right of exemption from the Fiscal Compact provisions (such as the stipulation of the structural budget balance rule monitored by an independent institution) of the Treaty until Eurozone accession. Improvements were made to the management of public debt. In November 2017, the government issued a EUR 1.25 billion bond as part of the refinancing of SOEs' debt. Besides reducing and fixing the interest rate and extending maturities, this enabled the authorities to concentrate a higher share of general government debt under the Treasury. In addition, the body assigned with debt management was upgraded to the level of a Directorate in the ministry of Finance, with increased staffing. Both these developments are expected to improve the effectiveness of debt management. Taxation

The Croatian tax system strongly relies on indirect taxes. In proportion to GDP, indirect tax revenues (19.7 %) in Croatia are three times higher than direct taxes (6 %). They are significantly above EU average (13.6 %), but also the average for the peer countries. () The already legislated introduction of the property tax was postponed with no indication of whether and when will it be implemented. This type of tax is generally regarded as one of the least detrimental to growth. The 2017 tax reform is expected to benefit only certain types of households. The reform, which most notably cut personal income tax rates and raised the personal tax allowance(), is projected to have decreased the tax liability for all households that were subject to income tax and increased the number of households that pay no tax. Simulations () project that the gains from the reform are largest at the lower end of the wage distribution in the cases of single earners and two-earner households with no children or one child. The tax wedge for a single worker (average wage) is projected to have decreased by 0.5 pp, with larger decreases for those earning 67 % and 50 % of the average wage (-2.3 pp and -1.2 pp, respectively). Decreases in the tax wedge for a two-earner household with two children are slightly larger at average wage level (-1.5 pp). However, the tax wedge for this household type does not decrease at lower wage levels (67 % and 50 % of average wage), as these incomes were not taxed already before the reform. Significant increases in the (non means-tested and non-capped) child tax allowances mean that the gains will have been highest for larger families at the upper end of the earnings distribution. The reform is projected to increase inequality and provide limited support to employment. Although the tax burden and tax wedge were already low before the reform, the reduction of the tax wedge should benefit employment. However, the increase in the dependent spouse allowance could decrease incentives to work for second earners. Since households in the lowest deciles of the overall income distribution are unlikely to benefit from the reform (), the Gini coefficient which measures income inequality () is projected to have increased. Table 4.1.1:Tax wedge comparison with peers Source: European Commission, OECD. Box 4.1.1: Efficiency of spending in Croatia The analysis in this box assesses efficiency of public spending by comparing inputs (spending in a certain category) with outputs or outcomes (indicators mirroring the performance in the respective category) across countries, using a BCC model II of data envelopment analysis (DEA). This approach measures relative efficiency of inputs (spending) and ranks countries accordingly. The best-ranked country is considered to be at the efficiency frontier. The distance to the efficiency frontier provides a perspective of how much a certain country could improve its outcomes with its current level of spending – or – how much spending a country could allocate elsewhere or save, keeping the same outcomes. As the robustness of results obtained using this method depends on how well the choice of the outcome indicator isolates the effect of spending from extraneous variables, its applicability is limited to several areas. The efficiency of Croatia's spending is assessed against those of its five CEE peers (Slovenia, Hungary, Slovakia, Czech Republic and Poland) in eight areas: police services, law courts, transport, health, education, research & innovation, social protection of people below 65 years of age and social protection of the elderly. Inputs in all cases relate to spending in the concerned category, but the time interval varies depending on both the nature of the category and the output indicators used. While healthcare and education are areas where spending takes a long time to produce results, this is to a smaller extent the case with police services, law courts or social protection. In the case of transport, infrastructure projects typically take a very long time to be completed. For this reason, in some instances average spending throughout a longer period is taken as input, but also the output indicator looks at progress made over the same longer period as opposed to the current state of play. The indicators and periods used are listed in the table below. The results of the analysis of efficiency of public spending in Croatia paint a rather consistent picture across spending categories. Croatia is at the efficiency frontier in only one area (Social protection of the elderly) whereas in other areas tends to be below average and in some cases the lowest among peers. This is the case especially when spending is expressed as a percentage of GDP rather than nominal spending per capita, in view of Croatia's low GDP compared to peers. In general, Croatia seems to fare worse in areas where its spending levels are high in comparison with peers, such as education or police services. Social protection of the elderly appears relatively ineffective but at the same time efficient. Namely, in the reference period Croatia had the highest share of elderly people at risk of poverty among peers (average of 24.3 % vis-à-vis the peer average of 9.5 % and EU average of 13.9 %), but at the same time Croatia's spending in this category was very low compared to peers. This result is in line with the pension adequacy risk highlighted by the Commission (see Section 4.3).When it comes to social protection of people below 65 years of age, Croatia's ranking is just below average (although still far from the efficiency frontier) while its spending levels are high with respect to peers (also due to the relatively high number of early retirees in Croatia). This confirms the view that their effectiveness of social benefits is hindered by poor targeting at those most in need and the existence of privileged categories such as war veterans (see section 4.3). In the area of transport, the relatively high spending seems to be moderately efficient, but here composition effects play a big role since spending in this category was very high in the first part of the period under consideration but sharply declined in the second part. In order to assess the robustness of the results, alternative indicators were tested, largely confirming the initial results. In three areas, alternative input indicators were tested, namely: the number of judges (law courts) and medical doctors (health) per 100 000 inhabitants and teachers per 100 pupils (education). In the case of health and particularly law courts, the use of the alternative indicator decreases Croatia's efficiency score, suggesting that inefficiencies could in part be traced back to the sub-optimal allocation of human resources, which is in line with the observed uneven workload of judges. In that sense, the reorganization of the judicial network (see section 4.5) could help reduce inefficiencies. On the other hand, in education the use of an alternative input indicator substantially improves Croatia's efficiency score. It should be noted that this analysis is based on data up to 2015. Given the extent of expenditure restraint recorded in 2016 and 2017 it is possible that the efficiency of spending has since improved. For a broader analysis of efficiency of spending in the EU, see European Commission (2016d). 4.2. Private sector debt and financial sector* Corporate debt Corporate debt decreased as a percentage of GDP and corporations lowered their exposure to foreign currency. In the first half of 2017, the corporate debt-to-GDP ratio decreased by an additional 2.8 pps, to 67.8 % of GDP. Overall, the debt ratio dropped by approximately 15.6 pps from its 2010 peak value of 83.4 % of GDP. The reduction has been driven mainly by a substantial contraction in domestic loans denominated in foreign currency (by 7.5 pps) and in external corporate debt (by 7.9 pps). However, the exposure of Croatian companies to currency risk remains high, as 75 % of corporate debt, equivalent to approximately 51 % of GDP, was debt contracted abroad or denominated in foreign currency (see Graph 4.2.1). Graph 4.2.1:Debt composition of non-financial corporations Source: Croatian National Bank and Eurostat. The economic recovery is supporting the reduction of corporate debt. Since 2015, the decrease in corporate debt has been mainly driven by dynamic economic activity, supported by the moderate pick-up in inflation in 2017. Write-offs and valuation effects, i.e. the appreciation of the Kuna against the Euro, also contributed to the reduction of corporate indebtedness since the first reduced the amount of non-performing loans, whereas the latter reduced the value of outstanding liabilities indexed to or denominated in foreign currency (see Graph 4.2.2). Debt reduction mainly took place in businesses in the hotel and restaurant sector as well as in the trade and construction sectors, which reduced their external loans by principal repayment, in addition to considerable write-offs. Taking into account the domestic banking sector only, negative credit flows to the corporate sector were still contributing to the reduction of corporate debt in 2015 and, to a small extent, 2016. However, in 2017, credit flows to the corporate sector had turned positive rising by 3.4 % - due to positive growth rates in the foreign currency segment more than compensating for the slightly decrease in flows in the domestic segment (see Graph 4.2.2). Graph 4.2.2:Contributions to change in total corporate debt-to-GDP ratio Source: Croatian National Bank and Eurostat. Interest rates have been on a declining trend over the last few years and are expected to stay at low levels. This trend is more pronounced in loans indexed to and denominated in foreign currency. The decrease started in the second half of 2014 with big-size loans, followed by medium-sized loans in 2016, stabilizing between 2 and 3 % thereafter. Interest rates on loans denominated in domestic currency also decreased, but remain above those of peers (see Graph 4.2.3). The decrease is least visible in the short-term segment. The decrease in interest rates in the long-term segment reflects the mild fall in yields to maturity on Croatian long-term government bonds, ample liquidity and greater competition among domestic banks, particularly in offering more competitive (re)financing conditions. However, the continued parallel decline in interest rates in the euro area together with the still relatively high country risk premium for Croatia resulted in a widening spread between interest rates on corporate loans in Croatia for short-term loans, but a narrowing one with regard to long-term loans (see CNB, 2017). Graph 4.2.3:Interest rates on bank loans to corporations Source: European Central Bank. The corporate debt ratio is not particularly high but subject to a number of vulnerabilities. Overall, by June 2017 the corporate debt ratio was close to the prudential threshold indicating potential risks and less than 10% of GDP above the level suggested by fundamentals. The decrease in the corporate debt ratio since 2010 has thus reduced risks significantly. One of the vulnerabilities is the high concentration of corporate debt in a few big companies, including also the Agrokor Group (see Box 4.2.1). Risks also arise in the form of high share of loans in foreign currency, especially for non-exporting companies. Notwithstanding the greater availability of less costly funding, corporate sector debt is also still exposed to interest rate hikes. However, this risk has been slightly reduced, due to an increase in the duration of average fixation period. In addition, both the ‘debt-to-gross financial assets’ and the ‘debt-to-equity’ ratios of the non-financial corporate sector are relatively high, highlighting potential solvency risks. Household debt Household debt as a percentage of GDP decreased further, despite the recovery of borrowing in 2017. By June 2017, the debt-to-GDP ratio in the household sector was down to 34.6 %, 7.3 pps below its 2010 peak value. In 2016, the reduction in the debt ratio was notably impacted by the statutory conversion of CHF-denominated loans into EUR-denominated loans (with interest rates capped at historical averages of equivalent EUR-denominated loans) at the end of 2015. In 2017, the pace of debt reduction slowed down despite intensifying economic activity, due to an upswing in credit flows (see Graph 4.2.5). On the one hand, credit standards for granting housing and consumer loans continued to ease throughout 2016 and early 2017, due to stronger competition among banks in offering more competitive (re)financing conditions, reduced costs of sources of financing and positive growth expectations. On the other, demand by households for loans picked up, due to growing consumer confidence, positive trends in the labour market and a favourable real estate market outlook (see Graph 4.2.4). Graph 4.2.4:Composition of household lending Source: Croatian National Bank and Eurostat. The composition of household debt has been progressively changing towards HRK denominated loans. HRK-denominated loans rose by 5 % of GDP between 2010 and mid-2017. In addition to a steady trend towards borrowing in the national currency that started in 2013, the Swiss-franc loan conversion led many clients to refinance their newly converted EUR-denominated loans with HRK-denominated ones, thus substantially reducing the amount of loans exposed to foreign currencies (see Graph 4.2.4). In addition to a reduced propensity by households to borrow in a foreign currency following the Swiss franc experience, also banks were inclined to provide more kuna denominated loans due to, among other things, an increase in kuna sources of funding in their liabilities. This, amid a general fall in interest rates, contributed to reduce both the interest rates on HRK-denominated loans and the spread between interest rates on HRK and EUR loans. Notwithstanding this, more than half the outstanding stock of loans is still exposed to exchange rate shocks. Graph 4.2.5:Contributions to change in total households debt-to-GDP ratio Source: Croatian National Bank and Eurostat.

The household debt ratio is not particularly high and the interest rate risk is decreasing. In mid-2017, the household debt ratio was well below the prudential country-specific threshold but above the fundamentals-based benchmark, suggesting that risks are limited, although there remains scope for some deleveraging. Due to its composition, risks to household debt mainly stem from possible exchange rate shocks or interest rate hikes. However, interest rates on loans for house purchases and consumer loans have been decreasing since the end of 2015 and are expected to stay at low levels. In addition, there has been a recent decline in loans with variable interest rates and a simultaneous slow increase in loans with fixed interest rates. Namely, since the end of 2015, there has been a 9.2 % increase in loans for house purchases with fixed interest rates. However, a possible rise in reference interest rates remains a source of risk for clients, which in turn exposes the banking sector to indirect credit risk. In September 2017, the CNB issued recommendations to credit institutions aimed at mitigating such risk. The recommendations aim at increasing the transparency of information provided to consumers on debt servicing conditions while encouraging banks to extend their offer of loans at fixed rates and minimise the cost for consumers of refinancing existing loans at variable rates into loans with fixed rates. Housing market As the economic recovery gained ground, real prices of dwellings picked up by 2.1 % in 2016 in spite of low demand from the household sector. The rebound in house prices witnessed since 2016 has been driven by increases in the prices of existing real estate, which are nevertheless still below their 2010 levels. By contrast, the prices of new residential properties have continued to decline. House prices on the Adriatic coast and in Zagreb have contributed to the growth, while prices in other parts of the country remain subdued. In recent years, helped by increasing incomes on the one hand and subdued price dynamics on the other, the price-to-income ratio has decreased, signalling improved affordability of housing. Nevertheless, private demand remains subdued. This can partly be explained by a combination of negative demographic trends and an already high rate of home ownership. Graph 4.2.6:Dwellings price developments Source: Croatian Bureau of Statistics. The abolition of tax exemptions was partly offset by the introduction of a subsidy scheme for first-time buyers. As part of the 2016 tax reform, the exemption from the property transaction tax for first time buyers was abolished. However, the new Act on State-subsidised Housing Loans aims to compensate, subject to certain criteria, first time buyers of residential property by providing more favourable borrowing conditions. The subsidy, funded from the state budget, covers half of the annuity during the first four years of the repayment period. Access to finance Companies' access to bank loans is gradually improving, also for small firms. Banks’ lending activity remains subdued, especially in the small business segment. According to the latest findings from the Survey on the Access to Finance of Enterprises, access to finance has generally improved, but on average remains more difficult for Croatian firms. In 2017, among the surveyed companies that applied for a bank loan, 71 % of them were granted a loan, compared with 61 % the year before. However, many surveyed companies (21 %) were still awaiting the outcome of their application, compared with 13 % the year before. Moreover, 11 % of all surveyed small firms did not apply for a bank loan due to fear of rejection, more than twice the EU average of 5 %. According to banks' responses to the bank lending survey, credit standards on loans to enterprises tightened mildly in the second and third quarters of 2017, with standards on loans to medium and small enterprises tightening the most. On the contrary, the latter experienced easing credit standards in the fourth quarter of 2017, while standards on loans to large enterprises kept tightening. Apart from direct bank lending, other sources of financing include loans and credit lines with subsidised interest rates from the Croatian Bank for Reconstruction and Development (HBOR), implemented through commercial banks () and loans from the Croatian Agency for SMEs, Innovations and Investments (HAMAG-BICRO), mainly to fund innovation and its commercialisation in entrepreneurship. The European Structural and Investment Funds aim to facilitate financing for small firms. A set of new financial instruments supported by the European Regional Development Fund (ERDF) are meant to ease access to finance for small businesses and consequently boost entrepreneurship in Croatia. The debt instruments amount to a total of EUR 280 million and are expected to leverage approximately EUR 800 million of private investment. They are being developed under two financing agreements. One is implemented by the government agency HAMAG-BICRO and mobilises EUR 170 million in micro and small loans, individual guarantees and guarantees combined with interest subsidy. This instrument has proved successful, with a total disbursement rate of 41 % with the cut-off date 31 December 2017. The other, signed in October 2017, will be implemented by the Croatian Bank for Reconstruction and Development (HBOR). It will make a total of EUR 110 million available in growth and development loans. Implementation of this agreement is expected to start soon, and is planned to raise total private capital of EUR 105 million. The first tranche was paid from HBOR to financial intermediaries (3 selected commercial banks) in December 2017, but nothing has been disbursed yet. Other sources of financing for companies remain largely underdeveloped. Over the past few years there has been very little progress in developing new venture capital funds in Croatia. The 2015 World Bank initiative on Innovation and Entrepreneurship Venture Capital Project – which aimed to strengthen risk capital financing for innovative small and medium-sized firms and start-ups in Croatia – did not produce results. However recently, thanks to incentive of ESI Funds funding, the Croatian government started negotiations with the EIF aiming at addressing early stage equity market needs. ESI Funds are expected to contribute EUR 35 million and the total expected leverage amounts to more than EUR 70 million. The agreement is planned to be signed by mid-March 2018 and the funds to start reaching beneficiaries by end 2018. In parallel, HBOR and EIF are discussing to jointly commit around EUR 70 million for later stage equity market needs. Both initiatives should provide significant support for Croatian venture capital and private equity market. EU funding recently supported a private equity fund with a target size of EUR 100 million, focusing on small firms in Croatia, Slovenia and Serbia (European Investment Bank, 2017), a sign that a venture capital ecosystem might be gradually taking shape. Financial sector Despite the Agrokor crisis, Croatian banks’ profitability and solvency have continued to improve since 2015. With a return on equity of 8.9 % in 2016, banks' profitability has largely recovered from the negative impact of the conversion of CHF-denominated loans (see Table 4.2.1). The solvency ratio is back to the level it had reached before the CHF conversion. Liquidity indicators remain relatively high. In 2016, the loan-to-deposit ratio dropped to its lowest level since 2004, before increasing mildly in the first half of 2017 as lending to the private sector started to recover. The stock of non-performing loans (NPLs) continues to decline in the private sector, albeit at a slower pace. Both the NPL stock and NPL ratio have continued their downward trend, although more slowly than in 2016 (see Graph 4.2.7). By June 2017, the NPL ratio stood at 11.7 %, up from 11.6 % in June 2016. As of June 2017, NPLs were still significant in the private sector. Among non-financial corporations, the NPL ratio is about 26.3 %. Based on CNB data (), NPLs particularly affect the construction sector, which alone constitutes 17 % of the total NPL stock and where the NPL ratio has been above 60 % since June 2014. A high level of NPLs may hamper the ability of banks to extend new credit to firms, thus (partly) explaining why credit flows for the corporate sector are still weak. In the household sector the NPL ratio reached 8.8 % in June 2017, about 3 pps lower than its 2015 peak. NPLs in the household sector are predominantly found among mortgage loans. The reduction in the coverage ratio, namely the ratio between accumulated impairments and NPLs, has been mainly due to (i) the use of provisions, as certain banks wrote-off their Agrokor exposures and (ii) amendments to the automatic provisioning rules(), which led to some amount of provisioning reversals (see Table 4.2.1). Table 4.2.1:Financial soundness indicators, all banks in Croatia Source: European Central Bank, Consolidated Banking Data. Graph 4.2.7:Evolution of NPLs and coverage ratio Source: Croatian National Bank. NPL sales continue to be the main contributor to the reduction in NPLs. NPL sales in 2017 are likely to compare closely to the previous year when total sales were already at historically high levels (see Graph 4.2.8). In addition, the overall economic improvement has led to an increasing share of restructured loans being reclassified as performing. In the upcoming period, this beneficial development may also be supported by the recently introduced amendment of reclassification rules by the CNB that enables banks to cure loans more easily and in line with the European Banking Authority guidelines. These positive developments have been offset by a net inflow of NPLs, which are partly due to defaulted exposures of banks to Agrokor entities. Well-functioning insolvency frameworks may facilitate the further reduction in NPLs. Graph 4.2.8:NPL sales and other NPL flows Source: Croatian National Bank. The impact of the Agrokor crisis on Croatian banks has been limited so far, but risks remain. Roughly one fifth of Agrokor’s total loans are estimated to be from Croatian banks, and most of their impairments have already been incurred in the first half of 2017. The resulting flow of new NPLs and the relevant losses have been less than those predicted under an orderly restructuring scenario in CNB’s top-down stress test exercise, conducted in early 2017 (Croatian National Bank, 2017). Nevertheless, the banking sector could be indirectly affected by its exposure to Agrokor’s suppliers and by the wider impact on the Croatian economy of the Agrokor crisis. Box 4.2.1: Crisis and restructuring of Agrokor With around 30 000 employees and 2.2 % of the total gross value added in the economy, the Agrokor group is the largest private employer in Croatia. Having faced serious financial distress in early 2017, Agrokor was put under extraordinary administration in April. The potentially large impact on the Croatian economy and financial stability prompted the government to introduce a special law intended at minimizing the risk of a disorderly restructuring in systemically important companies. The law authorised a court-appointed extraordinary administrator, supervised by a council of creditors, to administer the processes of operational restructuring and negotiation of a settlement with the company's creditors. Agrokor's core business operations thus suffered only minor disruptions, which allowed the group to benefit from another record tourist season in Croatia. In September an audit revealed that total liabilities in 2015 were over 20 % higher than previous official figures. Agrokor's equity thus turned out to be negative as borrowings stood at just over HRK 40 billion in 2016, representing more than 16 % of the country's total corporate debt or 11.5 % of GDP. Other liabilities, including most notably trade payables, amounted to more than HRK 16 billion (4.6 % of GDP). In January 2018, the Commercial Court in Zagreb issued a final list of creditors' valid claims towards Agrokor, which formed the basis for determining voting rights in the council of creditors ( III ). After the establishment of voting rights, a negotiation period ensues which is required by the special law to result in a settlement by mid-2018, or else the procedure will turn into regular insolvency. The still uncertain outcome of Agrokor's restructuring, particularly if no settlement is reached, poses a significant downside risk to the economic activity, as financial losses and possible operational disruptions in the group and its supply chain could be sizeable. However, the direct risk to the stability of the domestic financial sector should be contained, since the majority of Agrokor's borrowing relates to external debt contracted abroad, whereas Agrokor's debt held by the well-capitalised domestic banking sector is not highly concentrated.

The high exposure of the private sector to currency risks leads to indirect credit risk for the banking sector. At the end of December 2016, 86 % of total loans denominated in or indexed to a foreign currency were not hedged against currency-induced credit risk. Alongside the CNB recommendations to credit institutions discussed above and aimed at mitigating credit risk on consumer loans, the CNB enabled easier access to HRK funding of banks by amending the regulatory framework for monetary policy operations, as the high demand for HRK-denominated loans is putting pressure on the banking sector, due to an increasing problem of maturity mismatch. Indeed, banks may find it challenging to provide fixed-rate, long-term lending in HRK, given the lack of long-term HRK funding. In 2017 the Parliament passed a number of financial laws. In summer 2017, the parliament introduced new legislation which annuls the validity of certain existing loans taken with foreign creditors. The CNB and the ECB were not consulted on the draft law, the implementation of which may prove problematic given the lack of precise data on the loans concerned and the lack of clarity on some of its key provisions. The most affected bank has lodged a complaint with the Constitutional Court. In October 2017, the parliament adopted a law to transpose the Mortgage Credit Directive, and the related by-laws were enacted by the CNB subsequently. The authorities have not yet communicated the results and possible follow-up to the Asset Quality Review of HBOR in 2017. The Croatian National Bank oversaw the quality assurance and ensured that the AQR methodology closely followed the ECB methodology developed in 2014. One of the purposes of the AQR is to inform the government decisions on possible changes in the regulatory and governance structure of HBOR. The latter is indeed a development and promotional state-owned bank that presents a number of specificities, like a high share of direct lending (European Commission, 2017f). 4.3. Labour market, social policies and education* Labour market developments The unemployment rate in Croatia has been falling considerably over the past year, but labour utilisation remains low. The unemployment rate decreased from 13.4 % in 2016 to 11.1 %in 2017. The drop resulted from the combined effect of increases in the employment rate and in the activity rate. However, at 65.6 % in Q3 2017, the employment rate was still one of the lowest in the EU; the activity rate was 71.7 % (Graph 4.3.1), compared to the EU average of 78.2 %. Between Q3 2016 and Q3 2017, the rate of long-term unemployment (LTU) declined to 3.9 % of the labour force (-1.5 pps), moving closer to the EU average of 3.3 % (). Overall, the chronically low labour utilisation in the Croatian economy continues to weigh on potential growth and on the country's adjustment capacity. There are also large territorial disparities in labour market outcomes. Based on 2016 registered unemployment data by county (Croatian Bureau of Statistics), the highest unemployment rate was almost four times the lowest rate. Most counties with the highest unemployment rates were located in the Eastern and Central part of the country. Low participation and low employment are widespread across age groups and genders, and vulnerable groups are particularly affected. The activity and employment rate of both men and women are well below EU average. Men recorded the second lowest employment rate in the EU, while the employment rate of women is 10 pp lower than for men (56.6 % and 66.2 % respectively). Discouragement, skills gaps, care responsibilities as well as multiple pathways to early exits represent important barriers to employment (European Commission, 2017f). The rate of young people not in employment, education or training (NEET) (16.9 % in 2016) and the youth unemployment rate (26.4 % in 2017) both remain high. The employment rate of older workers in 2016 was the second lowest in the EU (38.1 %). Besides the numerous pathways to early exit from the labour market, this could also reflect insufficient focus on training for this age group. In 2016 at 37.9 %, the employment rate of low skilled workers was well below the EU average (53.6 %) and much lower than for medium and high skilled workers (see Graph 4.3.2). Finally, the activity gap between people with and without disabilities in 2015 was 28.9 pp above the EU average. Graph 4.3.1:Activity, unemployment, long-term unemployment, youth unemployment, NEET and employment rates Source: Eurostat, Labour Force Survey (LFS). Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights The European Pillar of Social Rights, proclaimed on 17 November 2017 by the European Parliament, the Council and the European Commission, sets out 20 key principles and rights to benefit citizens in the EU. In light of the legacy of the crisis and changes in our societies driven by population ageing, technological change and new ways of working, the Pillar serves as a compass for a renewed process of convergence towards better working and living conditions. Croatia faces challenges with regard to a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights. This is notably the case for equal opportunities and access to the labour market and fair working conditions. Unemployment rate is decreasing. However, Croatia still faces a high rate of young people not in employment, education or training (NEETs), and low employment rates while only few of the jobseekers participate in active labour market policy measures. Croatia has high shares of people at-risk-of poverty or social exclusion. Nonetheless, the share of early school leavers is relatively low. Low participation in the labour market applies in particular to older workers. Among 55-64 years olds the employment rate stands at 38.1 %. Croatia has in recent years not been successful in addressing this issue, and this is raising concerns for the adequacy of the pension system in a context of demographic change. The establishment of a network of Lifelong Career Guidance (LLCG) Centres across Croatia is a step forward in the integration of employment programmes. The Centres provide individual and tailored career guidance support to all Croatian citizens. One of their main aims is to create targeted measures for the identification and activation of youth NEETs. The Centres use a partnership-based model and work with relevant stakeholders at local and county levels. So far there are 13 Centres and the plan is to reach at least 22 by 2020. In addition, the Croatian Public Employment Service and the Ministry of Science, Education and Sports as well as the Ministry of Labour and Pension System have signed agreements on the establishment of data exchange systems between them. This will allow tracking the youth NEETs and exchanging changing data on the career intentions of students in their final year of study.

Active labour market measures are insufficiently targeted at vulnerable groups. In 2016 the participation of unemployed persons in active labour market measures (ALMPs) was very low, at 7 %. In early 2017, new ALMPs were announced, but from a preliminary evaluation, they do not seem to address the difficulties in entering the labour market for the long term unemployed and the low-skilled (). At the same time, the Croatian Youth Guarantee scheme is showing some promising results: it reached more than half (54 %) of NEETs aged 15-24 in 2016 (EU average 42.5 %), and 18 months after leaving the scheme, 68.3 % of participants were in employment. Regarding passive measures, the duration of unemployment benefits (relative to the qualifying contribution period) is short in Croatia, and the coverage (less than 15 % of the eligible population) remains low (European Commission, 2017a). As of 2017, there has been a decrease in the number of new hires on temporary contracts and a sharp increase in new permanent contracts. The pick-up in economic activity and the improving conditions on the labour market favoured an increase in permanent contracts (Graph 4.3.3). In Q3 2017 however, temporary employees as a percentage of total employment still stood at 22.5 %, against an EU average of 14.8 %. As far as self-employed workers are concerned, in 2016 their share in total employment decreased to 12 %, of which the largest group were farmers (30%). Graph 4.3.2:Employment rate by educational attainment Source: Eurostat. After years of wage moderation, wages have started growing again. Both nominal and real (GDP deflated) wage growth was negative in 2013 and 2014, followed by a slight increase in 2015. In 2016, nominal wages decreased marginally, while real wages stabilised as inflation was negative. Between 2014 and 2016, Croatia was amongst the EU countries with the highest gap between productivity and real wage growth, which supported cost-competitiveness gains (European Commission, 2017j). In 2017, the negotiated increase in public wages, combined with the improving economic conditions and the further tightening of the labour market are putting some upward pressure on wages. Nominal wages started growing again, at a projected rate of 2.5 % for the year as a whole, and are expected to continue growing at the same rate in 2018 and 2019. As inflation has turned positive, real wages are projected to have increased by 1.3 % in 2017 and to continue growing at a moderate rate of 0.4 % over the forecast horizon, remaining below productivity growth. The authorities have adopted changes to the minimum wage. At the end of 2017, the gross minimum wage was raised by 5 % to EUR 456, which corresponds to the 42.9 % of the gross average wage in Croatia. In order to minimise the impact on labour costs, the base on which the employer contribution is calculated was cut by 50 % for those workers that have been employed for a period of more than 12 months on the minimum-wage, which risks creating an important low wage trap. In 2016, the coverage of the minimum wage was relatively low (6.6 % of the employed) and its incidence most pronounced in the poorest counties of Croatia and in a few sectors. Graph 4.3.3:Employment change year-on-year Source: Eurostat, Labour Force Survey (LFS). The adoption of the announced legislation to harmonise wage setting for civil servants across the public administration has been further postponed. Initially planned to cover wage setting in the public sector as a whole, the new legislation will be enacted in two steps, first covering civil servants only, and at a second stage, public sector workers. Greater harmonisation of wage setting across the public administration would be achieved through the introduction of common wage grids and job complexity coefficients, based on more consistent job descriptions and skills frameworks. According to the authorities, the new legislation would also cover areas of the employment relationship of civil and public servants that are currently negotiated through collective bargaining. In the meantime however, the basic collective agreement regulating the rights of civil and public servants was renegotiated in December 2017, with validity until 2021. The collective agreements for six sectors expired in 2017 and are still due to be renegotiated. As far as state-owned enterprises (SOEs) are concerned, no further steps have been taken in setting up a coordinated system for collective bargaining. Social Dialogue is not yet a well-developed practice in Croatia. Formally, Croatia has an established social dialogue structure in the form of a National Economic and Social Council. Social partners are invited to provide written contributions before the adoption of National Reform Programmes and other relevant legislative initiatives. However, the interaction between the authorities and the stakeholders is over all limited, and mostly confined to the provision of written feedback on some of the government proposed measures. Another inhibiting factor is that fragmentation seems to be central to limiting the overall capacity of trade unions to engage in social dialogue. Social protection system The rate of at-risk-of poverty and social exclusion declined in 2016, but remains high. In 2016, a large share of the population – 27.9% – was at risk of poverty or social exclusion (AROPE), compared to 23.5 % in EU (Graph 4.3.4). The share of people persistently facing a high at-risk-of-poverty rate (AROP) () was 14.5 %, whereas the percentage of the population living in overcrowded households () was mor