EUROPEAN COMMISSION Brussels, 26.2.2020 SWD(2020) 510 final COMMISSION STAFF WORKING DOCUMENT Country Report Croatia 2020 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2020 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(2020) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Summary of the main findings from the MIP in-depth review 4.Reform priorities 4.1.Public finances and taxation* 4.2.Financial sector* 4.3.Labour market, education and social policies* 4.4.Competitiveness reforms and investment* 4.5.Environmental sustainability Annex A: Overview table Annex B: Commission debt sustainability analysis and fiscal risks Annex C: Standard tables Annex D: Investment guidance on Just Transition Fund 2021-2027 for Croatia Annex E: Progress towards the Sustainable Development Goals (SDGs) References LIST OF Tables

Table 1.1:Key economic and financial indicators - Croatia Table 2.1:Assessment of the 2019 country-specific recommendations (CSRs) assessment Table 3.1:MIP matrix Table 4.2.1:Financial soundness indicators, all domestic and foreign banks in Croatia Table 4.4.1:OECD Product Market Regulation (PMR) Indicators Table A.1:2019 country specific recommendations (and subparts) assessment 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 segment of demand Graph 1.2: Real convergence of central and eastern European Member States Graph 1.3: Current account and net international investment position Graph 1.4: Labour market trends Graph 1.5: Nominal wage growth: actual and predicted based on economic fundamentals Graph 1.6: GDP per capita in PPS as share of EU average (EU = 100) by country in 2016

Graph 2.1: Overall multiannual implementation of 2014-2019 CSRs to date Graph 4.1.1: Maastricht debt and interest developments Graph 4.1.2: Debt sustainability scenarios Graph 4.1.3: Fiscal stance 2011-2019 Graph 1: Healthcare sector: arrears and financial recovery programmes Graph 4.2.1: NPL flows Graph 4.2.2: Zagreb stock market activity, HRK billion Graph 4.2.3: Decomposition of y-o-y changes in private debt-to-GDP ratios Graph 4.2.4: Corporate debt and its fundamentals-based and prudential benchmarks Graph 4.2.5: New lending (% year-on-year growth in annual volumes) Graph 4.2.6: Household debt and its fundamental-based and prudential benchmarks Graph 4.2.7: House price (2015=100) and mortgage growth Graph 4.3.1: Employment rate by age group in Croatia and the EU Graph 4.3.2: Labour shortages in Croatia as reported by employers, 2008-2019(Q3) Graph 4.3.3: Population change (%) by county, 2001-2017 Graph 4.3.4: Relative dispersion of employment rates of different educational attainment groups in the EU Graph 4.3.5: At-risk-of-poverty or social exclusion rate and its components (AROP, SMD, LWI) Graph 4.3.6: Selected education indicators for Croatia and the EU (2018) Graph 4.4.1: Total factor productivity developments: Croatia and its peers Graph 4.4.2: Percentage difference in labour productivity at the aggregate and sectoral levels relative to the EU28 (2016) and percentage change (2012-2016)

Graph 4.5.1: Municipal waste treatment: Croatia and peers LIST OF Boxes Box 2.1: EU Funds and programmes to address structural challenges and fostering growth and competitiveness in Croatia Box 4.1.2: Croatia’s healthcare system and its financial sustainability Box 4.2.3: Affordable and sustainable housing Box 4.3.4: Monitoring performance in light of the European Pillar of Social Rights Box 4.4.5: Investment challenges and reforms in Croatia Executive summary Addressing structural weaknesses with lasting effect would enable Croatia to converge faster to the rest of the EU. The forecast is for Croatia to enjoy sustained economic growth this year, before growth tapers off in 2021 in line with weakening global demand. Stable economic growth for five years, coupled with prudent macro-fiscal stabilisation policy, has enabled the country to progressively reduce its high levels of public, private and external debt, and in turn contain the vulnerabilities of the economy. The unemployment rate has continued to fall, thereby raising the disposable income of households. However, in 2018, Croatia’s GDP per capita relative to the EU average was still at the same level as ten years earlier. Participation in the labour market and labour productivity remain low, and the business environment and the public administration are insufficiently supportive of faster economic convergence. Implementation of policy measures addressing these weaknesses is proceeding at an uneven pace. Stepping up and sustaining the momentum for reform while resisting policy reversals is particularly important in light of Croatia’s firm ambition to join the exchange rate mechanism and adopt the euro.( ) After five years of recovery, Croatia’s economic output in real terms in 2019 finally exceeded its pre-crisis level. Real GDP is estimated to have risen by 3% in 2019 following a smaller rise by 2.7% in 2018. Growth in 2019 was fuelled by improvements in the labour market and rising wages, as well as a noticeable pick up in investment. The increase in exports of both goods and services rebounded after a rather weak performance in 2018, but imports increased even faster, restraining output growth. Going forward, the pace of economic growth is expected to slow down. Real GDP is forecast to rise to by 2.6% in 2020 and by 2.3% in 2021. Despite having increased in recent years, potential growth remains relatively low, slowing the pace of economic convergence with the rest of the EU in real terms. After contracting significantly during the recession, investment in Croatia has been recovering over the last five years. The recovery was due to the uptake of EU funds, while residual private and public investment remains low. Nonetheless, the investment rate remained slightly below that of its peer countries and below the EU average. Investment is expected to rise over the next few years. Identifying investment needs in green technologies and sustainable solutions, and securing adequate funding will be crucial if Croatia is to meet its climate and energy objectives and shape a new growth model. Croatia has also investment needs in transport. Investing more in skills, research and innovation would boost Croatia’s comparatively low productivity. Croatia has made limited progress in addressing the 2019 country-specific recommendations. There has been some progress in the following areas: ·A new legal framework regulating agency-type institutions was adopted. However, the public administration remains highly fragmented at the local government level. ·The incremental implementation of the curricular reform has started in all primary and secondary schools. The authorities have also refocused active labour market policy measures to make them more effective. ·Electronic communication is being gradually extended to all courts and backlogs have been reduced in commercial court cases. A number of measures have been taken and action plans drawn up to lighten excessive product and services market regulations.

·Key railway projects have been set in motion, though there has been no significant progress in promoting sustainable urban transport. There has been limited progress in the following areas: ·The new Budget Act, which aims to improve the fiscal framework and better regulate the system of state guarantees, has still not been adopted. ·Improvements to the social benefit system are still at the preparatory phase, and the long-due legislation on civil and public service wages is at a standstill. ·A new legislation on whistle-blowers was adopted, but gaps remain in the framework to prevent and sanction corruption. ·There has been limited progress in reducing or scrapping non-tax parafiscal charges. The governance framework of majority owned state-owned enterprises has improved, but progress on selling off state-owned assets has been slow. ·Investment in R&D has increased substantially, but its efficiency remains low. Energy efficiency and investment in renewable energy are hampered by administrative and legislative hurdles. ·The administrative capacity to design and implement public projects and policies remains constrained, despite the establishment of an institutional framework for strategic planning. Croatia still faces a number of employment and social challenges to deliver on the principles of the European Pillar of Social Rights. Despite improvements in the labour market, Croatia’s employment rate remains low, especially for some categories of workers. The risk of poverty is still high and social transfers have limited capacity to reduce poverty. As regards education, the share of early leavers from education and training is one of the lowest in the EU. Croatia, however, lags behind on participation in early childhood education and care and quality of education. Croatia has reached its national targets under the Europe 2020 strategy on renewables (except in transport), on energy efficiency, greenhouse gas emissions, the employment rate, early school leaving, and poverty and social exclusion. Croatia is still to implement the policies set out in the National Energy and Climate Plan to reach the 2030 target for greenhouse gas emissions not covered by the EU emissions trading system. Transport emissions have increased and are a key challenge in reaching the 2030 target for greenhouse emissions. Croatia is within reach of achieving its target on tertiary education attainment. The country is still below its target for investment in research and development. Croatia performs well with regards to the United Nations Sustainable Development Goals (SDGs). Croatia has made significant progress in SDG 8 (decent work and economic growth) with a number of sub-indicators moving towards the EU average. However, in the area of peace, justice and strong institutions (SDG 16), there is room for progress, particularly regarding corruption. ( ) The main findings of the in-depth review contained in this report and the related policy challenges are as follows. The government debt ratio continues to fall and debt sustainability is improving. Thanks to budget surpluses and robust nominal GDP growth, the government debt ratio is estimated to have dropped to 71.3% in 2019. It is set to continue to fall despite further tax cuts and spending projected to grow faster than GDP. Having refinanced a large portion of its debt in recent years at record-low, fixed interest rates with longer maturities, Croatia has cut its spending on interest as a share of GDP to pre-crisis levels. Today, Croatia faces low fiscal sustainability risks in the short, medium and long term. The recent reversal of some key features of the 2018 pension reform may not significantly affect this assessment, but negatively affects inter-generational equity and future pension adequacy. The fiscal framework remains incomplete as the Fiscal Policy Commission is not fully functional and the Budget Act is not yet in place. The transparency of local budgets is improving, but smaller municipalities lag behind. In spite of increasing revenues, payment arrears continued accumulating in the healthcare system indicating problems with its financial viability. Thanks to the improved economic situation, Croatia has reduced private debt and associated vulnerabilities. The ratio of private sector debt to GDP continued to fall in 2019, primarily due to the rise of nominal GDP and the slow-down in new lending. An increased uptake of loans with fixed interest rates reduces exposure of households and companies to interest rate risk. The exposure of private sector debt to foreign exchange risk remains significant, but has fallen due to increased kuna lending in 2019. Croatia further reduced its external imbalances thanks to its positive current account balances. Croatia’s net international investment position has improved significantly since 2011, but remains below prudential levels and the levels indicated by relevant economic indicators. However, Croatia’s external liabilities to foreign creditors and investors are mainly in the form of equity, which helps mitigate risks. The current account surplus narrowed in 2019 due to the worsening trade balance, and it is expected to continue decreasing in 2020 and 2021. Despite this, Croatia is set to make further progress in reducing its external imbalances, primarily thanks to GDP growth. The unemployment rate continued falling in 2019 but participation in the labour market remains very low. Croatia’s unemployment rate is at its lowest recorded level and projected to fall further. The improvement in the labour market has benefitted several categories of job seekers, including the long-term unemployed. However, the share of the working age population in work or looking for work remains among the lowest in the EU across all age categories, particularly older workers (55-64). This is largely related to early retirement and low skills as well care responsibilities in the case of women. The administrative capacity of labour market institutions and their cooperation with social services remain limited. Furthermore, Croatia’s population is shrinking due to the negative natural increase rate and emigration flows, which particularly affect the less developed regions. These factors, together with skills gaps, combine to produce labour shortages, which are becoming more pronounced in a number of sectors. Reforms to improve the business environment and boost competitiveness and productivity growth proceed but at a slow pace. The drivers of competitiveness are gradually improving, but the regulatory environment remains burdensome to business. Despite recent reforms, certain professions remain highly regulated. Stringent regulatory requirements limit firms access to capital, reduce economies of scale, and restrict competition. The length of court proceedings is also a burden on businesses, although Croatia has made progress in rolling out electronic communication and reducing court case backlogs. Several anti-corruption measures are pending, and perceptions of corruption continue to have negative effect on the investment climate. Croatia has made slow progress in selling off its holdings in state-owned enterprises. State-owned enterprises continue to play an important role in the economy. Croatia is on track to meet its targets on divesting shares and stakes in non-strategic companies, though the targets are not ambitious. The recent adoption of the draft Law on Unvalued Construction Land, which is being discussed in the Parliament, opens up potential for future investments by providing clarity on land ownership. Initiatives are ongoing to strengthen and improve the governance of state owned enterprises. The efficiency of the Croatian public administration remains low, also due to the high fragmentation at the local level. Weak public sector performance and inefficient coordination within the public administration hamper policy effectiveness. The new legal framework for the harmonisation of the state agencies has been adopted. Croatia has taken steps to modernise and improve the uptake of e-government services. However, the wage-setting framework still lacks consistency across the public administration and public services, and the long-due legislation on civil service wages is at a standstill. At local level, the financial and administrative resources of numerous small municipalities do not match their responsibilities and competencies. This contributes to uneven public service provision across the country and raises administrative costs. Other key structural issues analysed in this report, which point to particular challenges for Croatia’s economy, are as follows.

Banking sector key indicators continued to move in the right direction, thanks to the positive overall macroeconomic situation. The profitability and capital position of Croatian banks remain solid, and the share of non-performing loans continues to fall. However, legal uncertainty persists in the banking sector arising from court cases related to loans previously indexed to the Swiss franc. Poverty in Croatia continues to fall but remains above the EU average. Improved conditions in the labour market have resulted in a further reduction in the share of the population at risk of poverty or social exclusion. However, lower income households are not benefitting as much from the improved economic conditions. The coverage of minimum income schemes is low, and Croatia’s fragmented social protection system is ineffective in easing labour market and social distress. The short average working life in Croatia often results in inadequate pensions. Early retirement continues to be widespread, with working lives in Croatia being among the shortest in the EU. This produces a considerably negative impact on pensions. People aged 65+ experience much higher risks of poverty or social exclusion compared to the rest of the population, and compared to the EU average. Croatia’s reversal of some key features of the reformed pension system that lengthened working lives has not helped to address this challenge. The reform is ongoing to raise the quality of education in Croatia but challenges remain. Participation in early childhood education and care has increased considerably, though it remains one of the lowest in the EU. The latest assessment of school pupils’ performance on reading, science and mathematics confirms that there are quality gaps in the educational system. Croatia has started the incremental implementation of the curricular reform in all primary and secondary schools. The aim of the reform is to address the weaknesses in the quality of school education. Vocational education and training does not offer sufficient workplace training. Participation in adult education also remains very low. Environmental sustainability rests on improving waste and water management, enhancing rail transport and renewable energy use. Increased investments in waste and water infrastructure is essential to sustain Croatia’s economic development. Moreover, an improved waste management would support the transition to a circular economy. In some regions, the environmental challenges are especially aggravated during the tourist season when population spikes. A modal shift from road transport to rail would help address the substantial negative externalities caused by accidents, congestion and pollution, benefitting labour productivity. While Croatia ranks well in terms of electricity production from renewable sources, there is still substantial unused potential, particularly in solar and wind energy. Removing regulatory barriers and developing a solid incentive framework would help Croatia in this regard. The Commission’s proposal for a Just Transition Mechanism under the next multi-annual financial framework for the period 2021-2027, includes a Just Transition Fund, a dedicated just transition scheme under InvestEU, and a new public sector loan facility with the European Investment Bank. It is designed to ensure that the transition towards EU climate neutrality is fair by helping the most affected regions in Croatia to address the social and economic consequences. Key priorities for support by the Just Transition Fund, set up as part of the Just Transition Mechanism, are identified in Annex D, building on the analysis of the transition challenges outlined in this report. 1. Economic situation and outlook GDP growth GDP growth is estimated to have picked up to 3% in 2019, following the slowdown in 2018. Following the peak of 3.5% in 2016, real GDP growth gradually slowed to 2.7% in 2018. This slowdown was more pronounced than expected but appears to have been temporary. Based on the strong results in the first three quarters of 2019, growth picked up to an estimated 3% for the whole year. Household consumption remains the main driver of growth, followed by a strong increase in investment. Investment benefited from strong uptake of EU funds amid sluggish private investment growth, despite favourable financing conditions. Exports of goods picked up in 2019 following a weaker second half of 2018. The rise in exports of services slowed partly due to capacity constraints in the peak months of the tourist season. Import growth fell slightly compared to 2018 but still exceeded the rise in exports, leading to an overall deterioration in the trade balance. Graph 1.1:Real GDP growth by segment of demand Source: European Commission Economic growth is expected to slow down due to external pressure. Strong domestic demand is expected to remain the main driver of growth. Household disposable income should be boosted by the continued rise in employment, increases in public and private-sector wages and low inflation. Underpinning the rise in both public and private investment, more EU-funded projects, from the current programming period, should be reaching the implementation phase in 2020 and 2021. Following a period of rapid market share gains, Croatia’s boom in exports is expected to slow down, partly due to uncertainties surrounding global trade and an economic slowdown in Croatia’s main trading partners. Overall, real GDP growth is expected to slow to 2.6% and 2.3% in 2020 and 2021 respectively. Croatia has experienced a lost decade in terms of economic catch up with the rest of the EU. Following a six-year recession and a moderate recovery, the volume of economic output only surpassed the pre‑crisis level in 2019. Similarly, Croatia’s GDP per capita in purchasing power standard was 63% of the EU average in 2018, the same value as in the last pre-crisis year (2008). Furthermore, Croatia fell further behind its more advanced peers ( ) in central and eastern Europe and was surpassed by others. Despite stable growth, Croatia’s still relatively low growth potential will continue to be a break on it catching up with the rest of the EU in real terms. Graph 1.2:Real convergence of central and eastern European Member States Source: Eurostat Investment Investment in Croatia remains weak and lower than investment in peer countries. Its investment share of potential GDP has been lower than its peers every year bar two years since 2001. With the collapse of Croatia’s pre-crisis growth model based on debt-financed consumption and public investment, gross fixed capital formation fell sharply. Since the start of the recovery, growth has primarily been driven by consumption and exports, with low investment due to the high private and public-sector debt overhang. In 2018, real gross fixed capital formation was still almost 20% below its peak in 2008. However, the injection of EU funds since Croatia’s accession to the EU in 2013 has boosted investment. The take‑up of funds is expected to peak in the next two years as more projects reach the implementation phase. Investment is expected to provide a higher contribution to growth in both 2020 and 2021. External position A weakening trade balance is forecast to reduce the current account surplus. After peaking in 2017 at 3.3% of GDP, the current account surplus started to narrow due to a progressively deteriorating trade balance. In 2018, the trade balance turned negative, as strong domestic demand drove an increase in imports. As a result, the current account surplus fell to 1.9% of GDP. However, when adjusted for cyclical effects, the current account surplus was 3.1% of GDP. The period of Croatia increasing strongly its export market share appears to have ended in 2018. It is expected to turn negative in 2019, due to a slowdown in Croatia’s largest trading partners. Exports to central and eastern European Member States have increased steadily since 2012 and are projected to stimulate further increases in exports. Overall, the current account balance is forecast to continue declining in 2020 and 2021 as the trade balance is expected to further deteriorate. Croatia has greatly reduced its external imbalances since 2010, thanks to sustained current account surpluses. The net international investment position was at -57.9% of GDP at the end of 2018, a 7.8 percentage point improvement since 2017 and around 42 percentage points above its record low. By September 2019, it had increased further to ‑49.7% owning to a particularly strong current account surplus in the third quarter of 2019. Gross external debt fell in 2018 by 6.2 percentage points, to 83% of GDP, mainly due to government and corporate deleveraging. External imbalances are projected to continue to fall, driven primarily by GDP growth. Graph 1.3:Current account and net international investment position Source: Eurostat Inflation and interest rates Headline inflation fell in 2019, despite rising disposable incomes and accelerating economic activity. HICP inflation fell to 0.8% in 2019 due to the full year effect of the 12-percentage point reduction in the VAT rate on some unprocessed foods. Compared to 2018, energy price inflation slowed, leading to a lower producer price inflation in 2019. Inflation is expected to pick up but remain moderate overall, at 1.5%, in 2020 and 1.7% in 2021. Core inflation, having remained stable in 2019, is projected to pick up in 2020 and 2021 to 1.8%. Low or negative energy price inflation and, to a lesser degree, a new 12-percentage points VAT reduction on food served in restaurants are likely to curb price increases throughout the forecasting period.

Interest rates fell amid high competition in the banking sector and improvements in Croatia’s risk profile. Lending conditions for new loans to households and non-financial corporations continue to ease, across all currency denominations, purposes and maturities. Banks’ net interest rate margins are thus being further squeezed, with deposit interest rates already close to zero. Given ample liquidity in the banking sector, moderate private-sector demand for credit and active debt reduction by the government, interest rates are likely to continue to fall. Stable growth and prudent fiscal policy contribute to a further improvement in Croatia's risk premium. The spread between yields on Croatia’s sovereign debt and the German bund dropped to 94 basis points in October 2019, well below most of Croatia’s peers and close to the EU average of 82 basis points. Private indebtedness Overall private-sector debt fell despite a moderate pick up in borrowing. In the first three quarters of 2019, consolidated household and corporate debt continued decreasing, reaching 34.3% and 58.4% of GDP respectively, some 8 and 24 percentage points below their peaks registered in 2010. This was facilitated by nominal GDP growth and a slight appreciation in the value of the kuna. Household borrowing accelerated, due to rising consumer lending. The corporate sector is still deleveraging, although new borrowing for investment purposes rose noticeably. Household borrowing is likely to increase further as consumer confidence remains high and improvements in the labour market increase people’s disposable incomes. Corporate lending is set to remain low given the high levels of debt and the share of non‑performing company loans. Public finances The general government balance remains in surplus. Following its first ever-recorded surplus in 2017, the general government balance deteriorated somewhat in 2018, but remained positive at 0.3% of GDP. The deterioration was mainly due to the short-lived impact of the call of the government guarantees in the Uljanik and 3. Maj shipyards. As in the previous three years, Croatia achieved further savings in interest payments. A high portion of debt was refinanced at much lower rates, while revenue growth continued to exceed GDP growth, despite tax cuts. The deterioration of the structural balance was more pronounced (1% of GDP), as the economy continued expanding after the output gap was closed. In 2019, the general government surplus is expected to further narrow to 0.1% of GDP as expenditure growth picks up (mostly due to public sector wages) and tax and social contribution cuts curb from revenue growth. Government debt is projected at 71.2% of GDP in 2019. By 2021 it is expected to reach 64.4% of GDP, due to the increase in GDP and small surpluses. Labour Market Although labour market conditions continue to improve, employment levels remain low. After peaking in 2013, the unemployment rate has fallen continuously due to increased employment and to significant emigration. In 2018, unemployment rate fell to 8.4%, the lowest recorded level. However, employment and labour market participation rates remain low, well below the EU average. Some groups of workers remain particularly vulnerable, namely the low skilled, elderly and the disabled. The activity rate is expected to increase gradually in 2020 and 2021, as improved labour market outcomes start drawing people out of inactivity. Despite relatively high unemployment, labour shortages are becoming more apparent in some sectors. . Graph 1.4:Labour market trends Source: Eurostat Wages continue to grow amidst low inflation. It is still difficult to interpret trends in wages due to large discrepancies in the data reported by different sources. National accounts show that nominal compensation per employee increased by 1.9% in 2018, while administrative data show that average gross wages rose by a more sizeable 4.9% in the same year (and 3.5% year-on-year in the first nine months of 2019). Looking ahead, nominal compensation per employee is projected to increase by 3% on average in the 2019-2021. In real terms, compensation per employee rose by 0.3% in 2018 and is expected to rise by 1.7% in 2019 and 2.5% in 2020, before slowing to 1.1% in 2021, underpinned by strong labour demand, public sector salary increases( ) and an increase in the minimum wage for 2020. Despite rising wages, Croatia has broadly maintained its cost competitiveness. Wage growth measured on the basis of administrative data is consistent with economic fundamentals( ). Nevertheless, in 2018, wage growth exceeded the rate consistent with preserving Croatia’s cost competitiveness, even though real wages rose less than labour productivity. Graph 1.5:Nominal wage growth: actual and predicted based on economic fundamentals Source: Eurostat, Commission calculations Social developments The share of people at risk of poverty or social exclusion is approaching the EU average. The labour market recovery after the prolonged recession is lifting many people out of poverty or social exclusion. People excluded from the labour market, the low-skilled, older people and people with disabilities remain most exposed to the risk of poverty or social exclusion. In-work poverty, already below the EU average, has fallen further. Income inequality, as measured by the S80/S20 income quintile share ratio, was just below the EU average in 2018, even though Croatia has one of the least progressive labour income tax systems in the EU, measured by comparing the difference in tax levels between high-income and low-income earners ( ). Gender inequality in Croatia is among the highest in Europe (European Institute for Gender Equality, 2019). Potential growth Croatia’s potential for growth is increasing but remains insufficient to achieve closer economic convergence. Potential growth is estimated to have increased gradually since 2010, but it remains low compared to that in peer countries. After 10 years of being a drag on growth, the labour contribution to potential growth turned positive in 2019, as the employment rate recovered and the activity rate improved marginally. Nevertheless, labour participation remains chronically low in Croatia. This, together with negative demographic developments, is a drag on potential growth. The contribution of capital accumulation is in line with Croatia’s peers but remains burdened by relatively high levels of corporate debt. Total factor productivity significantly lags behind peers due to poor allocative efficiency, weak goods and service market efficiency, insufficient competition in network industries, and weaknesses in public sector governance. Although Croatia’s potential growth is forecast to continue increasing in 2020 and 2021, it is set to remain modest for a catching-up economy, at 2.5% on average over the 2019-2021 period, one of the lowest among its peers. Regional Disparities A marked regional divide persists in Croatia. There are large differences in GDP levels between counties, and in particular between the capital and the rest of the country. In 2016, Zagreb accounted for 34% of national GDP, though it is home to only 19% of country’s population. Most of the population (65%) lived in areas with a GDP per capita below 55% of the EU average (2016). By contrast, GDP per capita in Zagreb was 107% of the EU average, and in four counties in eastern Croatia, it was but 34-36% of the EU average. These disparities reflect very diverse labour market outcomes. In 2018, the unemployment rate ranged from 4.7% in the City of Zagreb to 24.3% in the Sisak-Moslavina county. There is also a high correlation between labour market outcomes and demographic change. Although the population has decreased across the country since 2010, poorer regions, especially in eastern Croatia, have experienced much higher rates of decline driven by outmigration and ageing (see Section 4.3). Graph 1.6:GDP per capita in PPS as share of EU average (EU = 100) by county in 2016 Source: Eurostat Statistical issues Croatia is working on improving the consistency, completeness and timeliness of its statistics, but major gaps remain. In particular, measures are being taken to strengthen institutional and methodological capacity to collect, produce and disseminate statistics. On 21 October 2019, the Croatian Bureau of Statistics released partly revised annual national accounts for 1995-2017, with improved cross-domain consistency of aggregate data. Data on non-financial sectoral accounts have yet to be published.

Sustainable Development Goals Over the past five years, Croatia performed well in most areas covered by the United Nations Sustainable Development Goals (SDGs). Significant progress was achieved in SDG 8 (decent work and economic growth) with a number of sub-indicators converging towards the EU average. Croatia has also fared well in poverty reduction (SDG 1), where the percentage of the population at risk of poverty or social exclusion reduced substantially. However, as discussed in Section 4.3, Croatia ranks below the EU average in a number of labour market and social welfare indicators. Moderate progress was achieved in areas such as good health and well-being (SDG 3), quality education (SDG 4), affordable and clean energy (SDG 7), and industry, innovation and infrastructure (SDG 9). Areas where Croatia has made no progress include peace, justice and strong institutions (SDG 16) where a number of sub-indicators remain flat. Despite Croatia performing well in areas such as the gender pay gap and the gender employment gap vis-à-vis the EU average, gaps have widened from the objectives under SDG 5 (gender equality). Table 1.1:Key economic and financial indicators - Croatia Source: Eurostat and ECB as of 9-1-2020, where available; European Commission for forecast figures (Autumn forecast 2019)

2. Progress with country-specific recommendations Since the start of the European Semester in 2014, 57% of all country-specific recommendations addressed to Croatia have recorded at least ‘some progress’ ( ). ‘Limited’ or ‘no progress’ has been made in the remaining 43% of the recommendations (Graph 2.1). Implementation of the reform agenda has proceeded at an uneven pace in different policy areas. Most progress has been made on fiscal policy and labour market. There has been some backtracking on pensions. Graph 2.1:Overall multiannual implementation of 2014-2019 CSRs to date Source: European Commission Croatia has pursued a responsible fiscal policy but gaps remain in its fiscal framework. After timely correcting its excessive deficit in 2016 (which allowed it to exit the Excessive Deficit Procedure in June 2017), Croatia continued to pursue a prudent fiscal policy. Since 2016, Croatia’s structural balance remained consistently above its medium-term objective, in spite of some deterioration in 2018 and 2019. Regarding fiscal-structural reforms, the Fiscal Policy Commission is still not operational in line with the new Fiscal Responsibility Act. The new Budget Act, that aimed to improve the budgetary framework at central and local level and better regulated the system of government guarantees, has not been adopted. Croatia has taken measures to improve the functioning of the labour market and to reform its education system. Two successive reforms, implemented in 2013 and 2014, facilitated the use of fixed-term contracts and flexible types of work (distance work, part-time work, seasonal work and agency work), and simplified the procedures for terminating permanent employment contracts. In 2015, the assessment of disability claims was harmonised and moved to a new single expert evaluation body. The long-due legislation on wage-setting for civil and public servants has still not been adopted by the government. In 2019, the incremental implementation of the curricular reform has started in all schools, and active labour market policies have been refocused to make them more effective. Steps have been taken to improve the business environment, the justice system, and the resilience of the financial sector. Efforts to reduce the administrative burden and improve the competitiveness of the services’ sectors are advancing, while a review of parafiscal charges is on-going. Measures continue to improve governance of state-owned enterprises, and Croatia is taking steps to reduce state ownership in companies. The reduction of court backlogs and the resolution of older cases is hindered by the inflow of new cases, although measures to improve efficiency in the justice system are progressing. Insolvency procedures have been thoroughly revised and the weaknesses identified in the banking sector have been addressed following the comprehensive portfolio screening in 2014. The Croatian Bank for Reconstruction and Development has undergone an asset quality review that identified areas for improvement, some of which are being addressed. Reforms of the public administration, social benefits and healthcare systems, have progressed slowly. Measures to harmonise the regulation of state agencies are making progress, but the overall modernisation process of the public administration requires further policy action. Constrained administrative capacity and process complexity impair a more efficient implementation of EU co-funded projects. Measures aimed at improving social benefits and tackling payment arrears in the healthcare system remain limited. Key elements of the reformed pension system have been reversed. In December 2018, the parliament adopted an important pension reform package, which came into force in 2019. However, elements of the reform aimed at lengthening working lives were subsequently reversed in response to trade union demands. Croatia has made limited ( ) progress in addressing the 2019 country-specific recommendations (see Table 2.1). There has been some progress in the areas of education curricular reform and governance of state agencies. Some progress has also been made new package of active labour market policy measures. Croatia signed several contracts for key railway projects in 2019, thus making some progress in the area of sustainable transport. Extending the use of electronic communication in court proceedings and reducing backlogs in commercial court cases has led to some progress in the area of court proceedings. A number of measures aimed at the alleviation of excessive administrative obligations and the liberalisation of services were implemented, which led to some improvements in the business environment. Progress has been limited in other areas, such as reinforcing the budgetary framework, improving the social protection system, reforming wage setting frameworks, refocussing investment-related economic policy, improving corporate governance and intensifying the divestment of shares and stakes in state-owned enterprises, and in the prevention and sanctioning of corruption. At the request of a Member State, the European Commission can provide tailor-made expertise via the Structural Reform Support Programme to help design and implement growth-enhancing reforms. Since 2016, the Commission has provided this support to Croatia for over 50 projects. In 2019, several projects were finalised. For example, the Commission supported the collection, classification and analysis of local social benefits with improved reporting requirements. It also provided support to help simplify the registration of private businesses through the on-line platform START, which was launched in November 2019. In 2019, work started on improving the quality of the budgetary process, creating a framework for assessing the performance of public polices and contributing to better strategic planning. Support will also be provided for improving financial supervision. Table 2.1:Assessment of the 2019 country-specific recommendations (CSRs) assessment (*) (*)The assessment of CSR 3 does not take into account the contribution of the EU 2021-2027 cohesion policy funds. The regulatory framework underpinning the programming of the 2021-2027 EU cohesion policy funds has not yet been adopted by the co-legislators, pending inter alia an agreement on the multiannual financial framework (MFF). Source: European Commission Box 2.1: EU Funds and programmes to address structural challenges and fostering growth and competitiveness in Croatia Croatia is one of the countries benefiting most from EU support. The financial allocation from the EU Cohesion Policy Funds ( I ) for Croatia amounts to EUR 9.9 billion in the current Multiannual Financial Framework, equivalent to around 2.9% of GDP annually. By the end of 2019, the entirety of this amount was allocated to specific projects, while EUR 2.8 billion was reported as spent by the selected projects ( II )( III ) showing a level of implementation well below the EU average. While bringing about a more harmonious development through reducing economic, social and territorial disparities, EU Cohesion policy funding also contributes significantly to addressing structural challenges in Croatia. The Cohesion Policy programmes for Croatia have allocated EU funding of EUR 1.9 billion for smart growth, EUR 4.0 billion for sustainable growth and sustainable transport and EUR 2.2 billion for inclusive growth. In 2019, following a performance review ( IV ) EUR 301.3 million have been made available within performing priorities. EU Cohesion policy funding is contributing to major transformations of the Croatian economy. It promotes growth and employment via investments, among others, in research, technological development and innovation, competitiveness of enterprises, sustainable development (energy, environment and transport), employment and labour mobility. By 2019, investments driven by EU Funds have already supported 933 new enterprises as well as co-financed equipping 151 schools with IT equipment in order to increase skills of the students. With the objective of reducing greenhouse gas emissions, 4,287 households have improved their energy efficiency classification and 20 km of rail has been reconstructed or upgraded to promote the modal shift from the roads. Support allocated for improved wastewater treatment will benefit almost 1.6 million people. Support to 1,436 primary health care providers will improve access to healthcare, especially in remote and deprived areas. The European Social Fund has focused on supporting women by offering training and employment opportunities and skilling around 7,000 women, who will provide care services for nearly 30,000 elderly and disadvantaged people in their households. Within these interventions, women receive additional education for professions that are in high demand in their local community. Agricultural and fisheries funds and other EU programmes also contribute to addressing investment needs. The European Agricultural Fund for Rural Development (EARDF) makes available in total of EUR 2.38 billion, and the European Maritime and Fisheries Fund (EMFF) in total of EUR 344 million (including the national co-financing for both). Croatia also benefits from other EU programmes, such as the Connecting Europe Facility, which allocated EUR 430.5 million to specific projects on strategic transport networks, Horizon 2020 allocated EU funding of EUR 84 million (including 40 SMEs with about EUR 15.2 million). EU funding contributes to the mobilisation of important private investment. By the end of 2018, European Structural and Investment Funds (ESIF) supported programmes alone mobilised additional capital by committing about 553 million EUR in the form of loans, guarantees and equity ( V ), which is 5.6% of all decided allocations of the ESIF. EU funds already invest substantial amounts on actions in line with the Sustainable Development Goals (SDGs). In Croatia, European Structural and Investment Funds support 13 out the 17 SDGs and up to 95% of the expenditure is contributing to those. 3. Summary of the main findings from the MIP in-depth review The 2020 Alert Mechanism Report concluded that a new in‑depth review should be undertaken for Croatia to assess the persistence or unwinding of the imbalances (European Commission, 2019a). In spring 2019, Croatia was identified as having macroeconomic imbalances (European Commission, 2019b). The imbalances identified related to high levels of public, private and external debt, in a context of low potential growth. This chapter summarises the findings of the analyses in the context of the MIP in‑depth review that is contained in various sections in this report ( ). Imbalances and their gravity

Public debt remains high, but is falling rapidly. High general government spending and a significant fall in revenue, due to a severe and protracted recession, contributed to the accumulation of public debt that peaked at 84.7% of GDP in 2014. Public finances have since improved, due to reined-in spending and a tax-rich economic recovery. Croatia recorded its first fiscal surplus in 2017, and its second in 2018, despite a non-negligible materialisation of contingent liabilities. Overall, public debt remains high at 74.8% of GDP in 2018. Nevertheless, thanks partially to improvements in public debt management, debt is being refinanced at record low and predominantly fixed rates, with extended maturities. The improvements in public finances were recognised by Fitch and S&P agencies as they upgraded Croatia’s long-term sovereign credit rating to investment grade with a positive and stable outlook respectively, while Moody’s upgraded its outlook to positive. The private-sector debt profile continues to improve. The consolidated corporate and household debt levels for the third quarter of 2019 are estimated at 58.4% and 34.3% of GDP respectively, some 24 and 8 percentage points below the peak registered in 2010. Since 2017, both household and corporate debt levels have been below their respective prudential thresholds ( ). However, despite a significant reduction, both debt levels remain high compared to their thresholds based on fundamentals. Corporate debt also remains high relative to gross financial assets or equity, signalling a persistently high debt overhang and solvency risks for the corporate sector. The private-sector debt profile has also continued to improve. The share of foreign exchange risk exposed debt fell from 65.7% in 2018 to 63.1% in Q3 2019. The reduction reflects the increasing propensity of both businesses and households to borrow in domestic currency and repay their foreign-currency-denominated debt. Businesses and households are also benefiting from high competition in the domestic banking sector to refinance their loans with lower interest rates and longer periods of fixed interest rates. Although the current account surplus is shrinking, it is still helping to curb external imbalances. After peaking at 3.3% of GDP in 2017, the current account surplus narrowed to 1.9% of GDP in 2018, as the increase in imports of goods turned the trade balance negative. The current account surplus rebounded in the first three quarters of 2019 to 2.2% of GDP ( ) largely due to growing tourist receipts. Revised data on external liabilities, using improved methodology and standards, published by the Croatian National Bank in September 2019, show higher levels of gross external debt and a lower net international investment position (NIIP). However, the external imbalances continued to abate in 2018 and in the first three quarters of 2019. By September 2019, the NIIP stood at ‑49.7% of GDP, almost 50 percentage points above its record low, while the gross external debt was 81% of GDP, almost 40 percentage points below its peak in Q1‑2015. Nevertheless, compared to the prudential and fundamentals-based benchmarks (see section 4.2), Croatia continues to have very high external liabilities. Its net external position excluding non‑defaultable instruments (NENDI) was estimated at only ‑5.6% of GDP, significantly above the benchmarks, indicating a less problematic composition of external liabilities. Low potential growth remains an obstacle to Croatia catching up with the rest of the EU more rapidly. After reaching a low point in 2010, potential output growth has since increased significantly, estimated at 2.1% in 2019. Although this is higher than the EU average, it is the lowest among peer countries( ), indicating to Croatia’s limited convergence capacity, and explaining its relative falling behind. The labour contribution to potential growth turned positive in 2019, due to a gradual recovery of employment, though it remains one of the lowest among peers. Demographic trends and a chronically low activity rate are a drag on labour contribution to growth for future years. Capital accumulation makes a positive contribution to growth, though it, is held back somewhat by high levels of debt of the corporate sector and a cumbersome business environment. Total factor productivity contribution to potential growth remains low for a catching up economy and when compared to peers. Low efficiency of goods and services markets, insufficient competition in network industries, poor public sector governance, and a widespread influence of state-owned enterprises in the economy continue to depress productivity growth. Evolution, prospects, and policy responses Public-debt reduction is set to continue. The headline general government balance is expected to remain stable and close to balance throughout the period 2019-2021. Buoyant revenue and savings from refinancing the public debt at lower interest rates are offset by the agreed wage increases and the government’s commitment to cut taxes in 2019 and 2020. This is driving down the government balance in those years. Public debt is expected to continue to fall to 64.4% of GDP in 2021. The new Fiscal Responsibility Act brought in new and improved numerical fiscal rules. It also strengthened the role of and allocated more resources to the Fiscal Policy Commission. However, lacking an appointed chair it is not yet fully functional. The new Budget Act has yet to be adopted. Although moderate, credit recovery is slowing the reduction in the overall debt ratio. Nominal GDP growth and a moderate appreciation of the kuna contributed to a further reduction, although at a slower pace, of the overall private-sector indebtedness, in 2018 and the first three quarters of 2019. Deleveraging in the corporate sector continued while net borrowing remained low (although 2019 saw a noticeable pickup in new borrowing for investment purposes). Lending to corporations is likely to remain at moderate levels, given persistently high levels of debt and high, though decreasing, levels of non‑performing corporate loans (16.3% in the second quarter of 2019), especially in the construction sector. Borrowing by the household sector picked up, driven by strong consumer confidence and rising income, with the bulk of new lending being general-purpose cash lending. To prevent an unsustainable accumulation of new household debt, the Croatian National Bank recommended tightening banks-lending conditions. Despite the current account surplus closing, external imbalances should continue to fall. Due to the expected further deterioration of the trade balance, the current account surplus is projected to gradually decrease in 2020 and 2021( ). Strong domestic demand is set to drive an increase in imports while it is becoming increasingly difficult to increase share of exports. Although declining, the current account balance will aid the reduction of external imbalances above the level suggested by fundamentals, estimated at around −0.9% of GDP in 2019. The net international investment position is expected to increase to above −50% of GDP already in 2020 and to continue improving in 2021. Nevertheless, it will still remain below the levels suggested by prudential and fundamentals-based benchmarks (−40% and −24% of GDP in 2019 respectively). Significant structural reforms will be necessary to increase Croatia’s relatively low potential growth. Potential growth is projected to remain the lowest among Croatia’s peers throughout the 2019-2021 period. Although growth is expected to reach 2.8% in 2021, contributions from labour and total factor productivity growth remain relatively low. The unemployment rate is already at an all-time low (6.9% estimated in 2019), projected to fall further to 4.9% by 2021. Increasing the labour contribution to potential growth will thus require increasing Croatia’s persistently low activity rate. This may become increasingly difficult given Croatia’s demographic challenges, the complete reversal of the recent pension reform, which reduces the retirement age to 65, and low take-up of active labour market policy measures. Low allocative efficiency, the cumbersome business environment and an inefficient public sector continue to depress the total factor productivity contribution to potential growth. Overall, due to pro-cyclical wage increases, tax cuts and a pickup in public investment, the output gap is expected to widen further in 2019 and 2020 before narrowing in 2021. Overall assessment Moderate growth in Croatia continues to bring down the debt imbalances. Household and corporate debt remain high, despite significant improvements over the last few years. Household debt reduction slowed due to a strong recovery in lending, while businesses continue to reduce its debt, burdened by persistently high non‑performing loans. Both households and businesses are improving their risk profiles by taking up ample liquidity available and competition in the banking sector to refinance their old debt obligations. Public debt remains high, although prudent fiscal policy over the last two years has brought it down considerably. Similarly, Croatia’s external liabilities have fallen, thanks to sustained current account surpluses. Croatia’s low growth potential remains an obstacle to it catching up with the rest of the EU and to correcting macroeconomic imbalances with a lasting effect. Despite improvements in labour market outcomes, increasing the labour contribution to potential growth will require raising the low activity rate, which is set to be difficult especially given Croatia’s demographic challenges. Productivity growth remains curtailed by weak allocative efficiency, a cumbersome business environment, and an inefficient public sector. Policy implementation has been uneven and has even backtracked on pensions. Reforms in the education system and the business environment are progressing, with more action needed on public administration and the governance of state-owned enterprises. The authorities’ firm commitment to join the ERM II provides an impetus to reforms in important policy areas. Key aspects of the recent pension reform that aimed at lengthening working lives have been reversed (even before they were implemented), with no credible offsetting measures announced. The new pension law sets the general retirement age at 65 as of 2030, even lower than what was planned before the abandoned reform. Table 3.1:MIP matrix (Continued on the next page) Table (continued) Source: European Commission 4. Reform priorities

4.1.Public finances and taxation* Debt developments and sustainability Croatia’s government debt continues to decrease rapidly. The gross general government debt ratio is projected to have dropped from a peak of 84.7% in 2014 to 71.3% in 2019, and set to continue decreasing sharply in the following years. The decrease has been driven by a combination of the strong improvement in the government balance and robust GDP growth. Following the sizeable amount of guarantee calls in 2018-2019, the stock of remaining government guarantees also decreased from 2.7% of GDP in 2017 to 1.2% of GDP in September 2019, leaving Croatia’s level of contingent liabilities comparatively low. Graph 4.1.1:Maastricht debt and interest developments Source: Eurostat, ECFIN calculations Over the last four years, the sustainability of Croatia’s public debt improved substantially. Croatia has made extensive use of the low interest rates and its improved ratings to refinance maturing debt at record-low, fixed interest rates with longer maturities.( ) As a result, Croatia’s interest spending in proportion debt-to-GDP is projected to have already dropped below its 2009 level, when the debt ratio was below 50%. The spread between the interest rates on Croatia’s long-term bonds and the German bund dropped to 89 basis points by the end of 2019, well below most of Croatia’s peers and close to the EU average of 84 basis points – underlining the structural nature of the improvement. Further savings on debt servicing costs are expected in 2020-2021, as another HRK 30 billion of the most expensive outstanding debt (with interest rates averaging at 6.5%) matures. Graph 4.1.2:Debt sustainability scenarios Source: European Commission, Debt Sustainability Monitor 2020 Croatia faces low fiscal sustainability risks in the short, medium and long term. Based on the 2019 Autumn Forecast, the Commission early-detection indicator of short-term fiscal stress (S0) and the long‑term sustainability indicator (S2) indicate low risk, unchanged from the assessment in the 2019 country report. The S1 indicator of medium‑term fiscal risks has dropped substantially and now also indicates low risk. This assessment is confirmed by a debt sustainability analysis that points to low risk on account of decreasing debt across projection scenarios (see graph 4.1.2). It is important to note that this assessment does not account for the recent reversal of the 2018 pension reform. However, preliminary Commission estimates assess the long-term budgetary impact of the reform reversal as relatively limited, at 0.4% of GDP. While this means that public pension expenditure would remain on a downward trajectory over the long term, it also limits the potential to address the low level of pension adequacy (see Section 4.3.). For a detailed overview of the debt sustainability analysis, see the DSA standard statistical annex. Fiscal policy Following several years of prudent fiscal policy, Croatia’s fiscal policy stance is turning slightly pro‑cyclical. Over the period 2015-2017, the structural primary balance improved in parallel with improving economic conditions, which was particularly important given the still high public debt at the time. In 2018-2019, expenditure restraint weakened and some tax cuts were introduced, turning the fiscal stance into pro-cyclical, although this was partly due to the materialisation of contingent liabilities in shipyards. Going forward, the fiscal stance is expected to remain pro-cyclical as tax cuts curb revenue growth and expenditure growth remains robust, driven by public sector wage increases. Graph 4.1.3:Fiscal stance 2011-2019 Source: Eurostat, ECFIN forecast Fiscal framework The Fiscal Policy Commission is still not fully functional and the planned reform of the budgetary framework is not yet in place. The Fiscal Responsibility Act, introducing new and improved numerical fiscal rules and strengthening the independent status of the national Fiscal Policy Commission, was finally adopted in 2018. However, the Commission is still not operating in line with its new provisions. Namely, attempts to appoint the chair of this body were unsuccessful. In addition, the new Budget Act, which should improve both the short and medium term budgetary framework at central and local level and address vulnerabilities in the system of government guarantees, has still not been adopted. The transparency of local budgets is improving, though smaller municipalities lag behind. The average transparency score of municipality budgets (developed by the Croatian Institute of Public Finance ( )) rose substantially between 2015 and 2018. However, there are visible differences in the scores of small and large municipalities. The 42 municipalities with a population below 1,000 earned an average score of 2.5 in 2018, compared with 3.8 for the 42 most populous municipalities (with 5,000 inhabitants and more). The median size of the municipalities with the most transparent budgets (18 municipalities with a score of 4 or 5) is 2.5 times that of the municipalities with the least transparent budgets (24 municipalities with a score of zero). Smaller local government units also tend to have more irregularities detected by audits: in 2016-2017, only 35% of the local government units with less than 5,000 residents received an unqualified positive opinion from the State Audit Office, compared to 47% of government units with 5,000 residents or more. These findings are in line with the identified inefficiencies of Croatia’s highly fragmented system of local government, characterised by the difficulties of smaller municipalities to deliver quality services to their citizens (see Section 4.4.). Taxation Croatia’s taxation system is strongly skewed towards indirect taxation. Croatia is among the Member States which collect the least revenue from direct taxes. This is partly a consequence of very low property taxes, which are considered to be among the most growth-friendly taxes. The low share of direct taxation is also a reflection of low taxes on capital as well as successive cuts in the personal income tax implemented over the past 4 years. Aimed at reducing the tax burden on labour, the cuts have resulted in more than half of persons in employment not being liable for any personal income tax. Still, Croatia ranks around the EU average when it comes to revenue from social contributions in proportion to GDP, despite having the third lowest employment rate in the EU. At the same time, Croatia collects the highest share of VAT revenue in proportion to GDP of all EU Member States. At 3.6% of GDP in 2018, Croatia’s revenues from environmental taxes were above the EU average of 2.4%. However, there is scope to improve the use of environmental taxation to better support environment and climate policy objectives. Croatia is one of the few Member States that does not have a landfill tax nor an incineration tax for waste management (EEA, 2016). In 2020, the personal income tax is being cut again, this time for young people. A new tax break for young people fully exempts people under the age of 25 from personal income tax liability, whereas those aged 26-30 will pay 50% of their standard liability. The measure will likely result in taxation spikes when turning 26 and 31, while its overall budgetary effects are expected to be small due to the already low share of persons in employment who pay personal income tax, in particular among young people. The reduction of the standard VAT rate is being reversed and the scope of the reduced rate broadened. A reduction of the standard VAT rate (which at 25% is the second highest in the EU) was legislated in 2018, but was later reverted before taking effect, while the 13% reduced rate is being applied to more commodities. After several key foods were shifted to the reduced rate regime as of 2019, from 2020 food served in restaurants will also be taxed at the reduced rate. This measure is primarily intended to address labour shortages in the tourism sector. Restaurant services had already been taxed at a reduced VAT rate of 10% in 2013 and 13% in the period 2014-2016, with the aim of increasing the international competitiveness of Croatia's tourism. However, the VAT rate was then brought back to the standard one in view of the observed limited impact of the cuts on prices. The above mentioned changes of policy course and reversals of already legislated tax cuts negatively affect the stability of tax policy. In 2018, it took medium-sized companies an average of 206 hours to comply with their main tax requirements, significantly above the EU average of 172 hours per year (World Bank, 2019b). Box 4.1.2: Croatia’s healthcare system and its financial sustainability Despite the strong increase in revenue from health contributions, the healthcare sector continues to accumulate arrears. As of 1 January 2019, the health contribution rate was raised by 1.5 percentage points. Coupled with growing employment and wages, this is estimated to have increased the revenue of the Croatian Health Insurance Fund (CHIF) by 11% (year-on-year) in 2019. In spite of this, payment arrears to suppliers of goods and services are estimated to have grown by over 15%. Furthermore, expenditure is expected to grow strongly in 2020 on the back of wage increases in the sector agreed in September 2019 and the Supreme Court ruling from December 2019 which upheld doctors’ claims on unpaid overtime. Arrears are mostly generated in hospitals, particularly those owned by counties. The hospitals’ revenues are largely comprised of transfers from the CHIF, which are based on diagnosis-related groups and upper limits set by the CHIF. This combination of payment methods aims at reducing hospitals’ costs and increasing their efficiency. With some of the county hospitals’ budgets barely covering personnel costs, arrears quickly pile up. Faced with the prospect of suppliers suspending deliveries, the central government settles such arrears through ad hoc financial recovery programmes. There have been 12 such interventions since 2000, ranging from 0.1 to 0.6 per cent of GDP in a given year. There are several factors that contribute to the piling up of arrears in hospitals. Service is maintained in some hospitals in close proximity to each other where this is not justified by population size, and moral hazard often arises from the combination of local governments as owners of most hospitals and the central government as their source of financing. Furthermore, there is a lack of mechanisms and incentives for ensuring financial accountability of hospital managers. Functional integration of hospitals (six pairs for the time being) is aimed to rationalise the hospital network by modifying their functioning to respond to the needs of populations they serve. Graph 1:Healthcare sector: arrears and financial recovery programmes Source: Ministry of finance, Ministry of health Several initiatives were taken to improve the functioning of the health system, which remains focused on acute care. Around 45% of all hospital purchases are procured centrally, up from 8% in 2016, enabling substantial savings. However, while centralised procurement is mandatory for all state owned hospitals, many health institutions owned by counties opt to purchase individually. In September 2018, the government adopted the National Hospital Development Plan 2018-2020, the implementation of which should address some of the problems of hospital sector, namely rationalisation of the hospital network and reducing the reliance on acute care. Croatia is preparing its e‑Health Strategic Development Plan 2020-2025 and aims to launch a national mobile application allowing patients to schedule appointments. Additionally, preparatory work has been done to link up hospitals to a central calendar to manage waiting lists more effectively, but implementation may take longer than planned due to interoperability issues. Referrals from general practitioners to specialists were substantially reduced in the last decade. Still, the system remains focused on acute care provided in hospitals, while integration of preventive, chronic and long-term care remains low (OECD & European Observatory on Health Systems and Policies, 2019). Access to health care in Croatia is relatively good, with a low level of unmet needs for healthcare. At 1.4%, the share of people who declare unmet medical needs in Croatia is below the EU average of 2%. However, unmet needs due to geographical distance are higher in Croatia than in any other EU Member State. The geographical distribution of health care infrastructure and human resources varies considerably and there are a number of hospitals close to each other offering the same types of services (OECD, 2019). Also, unmet medical needs affect 4.1% of people aged 65 and above, well above the EU average of 2.5%. At 4.5 percentage points, the difference in unmet needs between the poorest and the wealthiest 20% of the population is also considerably above the EU average. Sickness and health care benefits are designed to help bridge this gap for the poorest. However, while they are well targeted, they are low. Only 4% of households are affected by out‑of‑pocket health expenditure exceeding 40% of their total spending net of subsistence needs (so-called ‘catastrophic health expenditure’), which can be considered low. The health status of the Croatian population is improving, but vaccination rates are dropping. Life expectancy has increased from 74.6 years in 2000 to 78 in 2017, in line with the overall EU trend (from 77.3 to 80.9 in the same period) and the life expectancy gender gap (6.1 years) exceeds the EU average. However, both preventable and treatable mortalities, which are proxies for effectiveness of health care system, are well above the EU average. The prevalent preventable causes are lung cancer, heart disease, alcohol use and accidents. High mortality from treatable diseases is primarily a result of cardiovascular diseases and colorectal and breast cancers. This owes in part to underdeveloped preventive medicine initiatives like awareness-raising, disincentives to smoking and alcohol consumption and promotion of healthy diet and lifestyle. Vaccination rates are dropping below levels which ensure a population’s immunity (95%): for the first time in 20 years, coverage with the first dose of the measles-mumps-rubella (MMR) vaccine dropped below 90% in 2016, whereas for diseases like measles, diphtheria, tetanus and pertussis the coverage was 93%. At 21%, the rate of influenza vaccinations of people older than 65 years is less than half of EU average. This situation owes largely to the anti-vaccination movement gaining popularity in the country. During 2019, the Croatian authorities have taken educational initiatives aimed at fostering vaccination rates, especially in paediatric and school medicine. 4.2. Financial sector* 4.2.1.Financial sector

Croatian banks have a healthy level of profitability and capital. With a return on equity of 11.3% (EU average: 6.4%) in the first half of 2019, profitability remains relatively high (see Table 4.2.1). This has largely been due to significantly lower provisioning levels than in the past few years. The total capital ratio fell slightly to 20.7% in mid-2019, due to the increase in general-purpose cash loans, which carry relatively high risk weights. The impact of the higher risk weights for non-kuna government bonds, which reduced the regulatory capital ratios in 2018, was offset by the sovereign rating upgrades in early 2019. Croatian banks remain well capitalised, with a CET1 ratio of 19.9% (EU average: 15.0%). Croatian banks are not expected to encounter problems in meeting the minimum requirement for own funds and eligible liabilities (MREL) given their current capital levels. The volume of non-performing loans (NPLs) continues to fall, albeit at a slow pace. The headline NPL ratio for the Croatian banking sector dropped to 6.9% (ECB figures) in June 2019, down from 8.7% a year ago. In absolute terms, annual NPL reduction has slowed down over the past year. This is largely due to an increase in the inflow of NPLs and to the lower volume of loans sold (Graph 4.2.1). The increased inflow of defaults are due to the write-downs arising from the Agrokor settlement in the second half of 2018. The slowdown in sales can be explained by a combination of demand factors (i.e. lower investor interest in remaining assets) and supply factors (i.e. banks’ willingness to hold NPLs). Nearly two-thirds of this stock remains concentrated in the non-financial corporate sector (NFC), resulting in an NPL ratio of 16.3% of all NFC loans, down from 20.7% a year ago. The construction sector continues to account for a significant proportion of the NPL stock, with an NPL ratio of 39.1% (local data) ( ), down from 53.5% a year ago. It is much smaller in the household sector at 5.9% in June 2019, down from 7.6% a year ago. Graph 4.2.1:NPL flows Source: Croatian National Bank (CNB) Table 4.2.1:Financial soundness indicators, all domestic and foreign banks in Croatia Source: ECB Consolidated Banking Data There is a significant amount of excess liquidity in the banking system. All banks meet the liquidity requirements with relative ease, (liquidity coverage ratio (LCR): 165% and net stable funding ratio (NSFR): 148%). This is thanks to the substantial amount of liquid assets on their balance sheets. In mid-2019, nearly 45% of the total assets of the Croatian banking system were held in low interest-yielding liquid assets such as government bonds, currency and central bank deposits. The closure of the credit registry (HROK) has had a negative impact on credit risk assessment. Credit information reported to the registry stopped for individual reports in May 2018 due to legal risks emanating from the entry into force of the General Data Protection Regulation (GDPR). Over the past year, several banks experienced difficulties in determining the overall level of debt of a borrower, information that is necessary for making appropriate credit decisions, including new creditworthiness assessments. The register partially resumed operations for delinquent loans in August 2019 and reporting on the remaining items (i.e. positive, non-default information) is expected to recommence by May 2020. The Croatian Bank for Reconstruction and Development (HBOR) is implementing recommendations from the 2017 Asset Quality Review. A number of projects are being carried out with support from the Structural Reform Support Programme (SRSP) including support for development of HBOR’s medium-term strategy improving credit rating and scoring models, as well as upgrading HBOR’s IT infrastructure. While the authorities may setup a working group to evaluate the different approaches to supervising HBOR, they have not committed to strengthening its supervisory framework. Since January 2018, HBOR has implemented IFRS9 along with all banks in Croatia. The new reporting framework resulted in shifting a portion of HBOR's portfolio into higher risk categories, including guaranteed loans provided to Croatian shipyards. The implementation of IFRS9 rules resulted in a non-performing loan ratio of 18.5%, broadly unchanged from 2017 (if the same standards were applied). . The main challenges for the non-bank financial sector are low interest rates and the limited depth of capital markets. The concentration of investment in debt securities, primarily sovereign bonds, puts pressure on profits of all financial institutions. This applies particularly to life insurers, which face severe difficulties in generating sufficient returns to meet their obligations. More generally, low rates expose insurers, pension funds and investment funds to the risk of asset revaluations due to changes in the base interest rate and risk premium. With no alternative high yielding investment opportunities, real estate investments are becoming increasingly attractive to financial institutions. Although the real estate market is not experiencing excessive growth, the concentration of exposures is a source of systemic risk. Low interest rates also reduce compliance costs as insurers step into the new international financial reporting standard under IFRS 17. Joining the Euro area could alleviate some risks in the banking sector. A greater use of fixed-rate loans has shifted the interest rate risk to banks. However, hedging instruments remain costly due to the low availability of interest rate derivatives in local currency. In addition, the indirect credit risk stemming from currency mismatches, which is significant for non-financial corporations (see section 4.2.2), will largely disappear if Croatia joins the Euro area. Legal uncertainty persists in the banking sector, arising from Swiss franc foreign-currency-indexed loans, including loans that have matured. A September 2019 judgment by the Supreme Court effectively confirms the June 2018 High Commercial Court decision that upheld the legal nullity of Swiss franc (CHF) foreign-currency clauses. The Supreme Court found that banks had breached the collective interests and consumer rights of borrowers by extending CHF-denominated or -indexed loans, without properly informing the customers of all the conditions for making an informed decision. This decision paved the way for individual borrowers, including borrowers whose loans have matured, to seek compensation from banks for overpayment and other damages. Access to finance Several EU funding programmes have been put in place to boost funding to companies with a high growth potential. Support from European Structural and Investment Funds (ESIF), and in particular the European Regional Development Fund (ERDF), helped fund over €1 billion of investment since 2014. Nearly half that amount was made up of favourable loans and guarantees, promoted by The Croatian Agency for SMEs, Innovation and Investment (HAMAG-BICRO). ESIF loans for growth and development targeting SMEs operating for at least two years took the lion’s share of funding. The Croatian Venture Capital Initiative was established in June 2018 to kick-start risk capital investments in start-ups. It has raised €12.2 million of private-sector funding, on top of the original €35 million injection from the European Investment Fund (EIF) ( ). In January 2019, the EIF and the Croatian Bank for Reconstruction and Development launched the Croatian growth investment programme, a €70 million co-investment programme to support fast-growing SMEs. In July 2019, a grant scheme targeting innovative SMEs (‘Innovations in S3 areas’) was launched with funding of €85 million. The Croatian securities markets remain highly underdeveloped with a relatively low turnover. The corporate bond market remains very small, limited to a few large issuers. As of June 2019, only nine active corporate issuers, including two foreign-owned banks, had active bond listings on the Zagreb Stock Exchange, with an average market capitalisation of less than 1.5% of GDP. Outstanding government bonds had a domestic market capitalisation of around 30% of GDP. The average market capitalisation of the local stock exchange was HRK 261.9 billion as of October 2019 (Graph 4.2.2), or 61.2% of GDP. This represents an improvement since end-2018 figures, when several Agrokor related losses were recorded. Ever since the global financial crisis of 2008-9, turnover on the stock market has been very low at around 1% of total market capitalisation ( ) per year. Graph 4.2.2:Zagreb stock market activity, HRK billion Source: Zagreb Stock Exchange (ZSE) Other sources of equity financing for companies are being developed. In January 2019, the Zagreb Stock Exchange launched the progress market, a new ‘SME Growth Market’ ( ) with support from the European Bank for Reconstruction and Development. This aims to encourage start-ups and SMEs to issue securities with less restrictive listing and reporting requirements. As at end-October 2019, five companies have issued equity on the progress market, with a market capitalisation of HRK 1.0 billion. As in the prime market, turnover on the progress market is extremely low for the moment (0.7% of market capitalisation). However, recent amendments to the Mandatory Pension Funds Act could increase interest and liquidity in this market ( ). Another recent initiative is the Adria Prime Index, which consists of five Croatian and nine Slovenian companies listed on the ZSE. Although still at an early stage, this initiative could help attract interest from international investors to the region. 4.2.2.Private-sector debt The private-sector debt-to-GDP ratio continued to fall in 2019. Since joining the EU in 2013, private-sector debt has fallen by 23 percentage points to 93% of GDP. The main reasons for the lower debt since the beginning of 2018 were nominal GDP growth (Graph 4.2.3) and the exchange rate appreciation against the euro. The increase in new lending has slowed, driven by a slow-down in lending to the corporate sector. Credit growth to the private sector rose at an annual rate of 3.1% in the first half of 2019. High levels of kuna liquidity in the banking sector continued to grow, supporting the favourable financing environment. The exposure of private-sector debt to foreign exchange risk remains significant, despite falling due to increased kuna lending in 2019. Graph 4.2.3:Decomposition of y-o-y changes in private debt-to-GDP ratios Source: Eurostat Corporate debt

Consolidated non-financial corporate sector debt fell by 1.9 percentage points in the first three quarters of 2019 to 58.4% of GDP. This came on the back of GDP growth and the appreciation of the kuna. Total loans to the corporate sector fell by 3.0% on an annualised basis in September 2019, due to several one-off effects such as the renegotiated or restructured loans in the Agrokor settlement and loans to troubled shipyards. In 2018, the corporate debt ratio was 6 percentage points below the prudential threshold estimated for Croatia, but almost 21 percentage points above the fundamental-based benchmark (Graph 4.2.4), indicating scope for further debt reduction ( ). New lending to non-financial corporations slowed in late 2018 and in early 2019 (Graph 4.2.5). New lending to corporations continued to be skewed towards large corporations. Graph 4.2.4:Corporate debt and its fundamentals-based and prudential benchmarks Source: European Commission The favourable macroeconomic environment helped reduce vulnerabilities in the corporate sector. Given the favourable environment for debt refinancing, corporates optimised their funding by reducing interest rate risk. The share of loans with a fixed interest rate increased by 3 percentage points in 2018. Interest rates on new bank loans to the corporate sector decreased in 2019, especially the interest rates on working capital loans indexed to a foreign currency. The exposure of the corporate sector to currency risk is increasing for new business loans. The share of foreign currency loans and loans indexed to a foreign currency in total new loans decreased to 42% in 2019, from 48% the year before. This contrasts with foreign-currency (denominated and indexed) corporate deposits, represented only 12% of foreign-currency loans in September 2019. Graph 4.2.5:New lending (% year-on-year growth in annual volumes) Source: Croatian National Bank (CNB) Household debt The stock of household debt increased slightly to 34.3% of GDP in the third quarter of 2019 from 34.2% at the end of 2018. The growth in mortgages reached an annualised rate of 4.8% in August 2019. In 2018, the household debt ratio remained almost 18 percentage points below the prudential threshold for Croatia (52%), but 10 percentage points above the fundamentals-based benchmark (24%) (Graph 4.2.6). Loans to households increased by 7% annually in September 2019, driven mainly by the increase in general-purpose cash loans. A higher take-up of these loans, which are innately riskier, seems to be largely due to the tighter lending requirements for housing loans, partly due to local implementation of European Banking Authority (EBA) guidelines on creditworthiness assessments ( ). In February 2019, the CNB recommended that banks level out the conditions for assessing the creditworthiness of housing and non-housing loans with longer maturities. Graph 4.2.6:Household debt and its fundamental-based and prudential benchmarks Source: European Commission The interest rate exposure of households remains high, but continues to fall as fixed-rate loans become increasingly common. The share of loans granted with fixed rates is increasing. At the end of 2018, 38.3% of total outstanding loans were with fixed interest rates, up from 33.7% a year earlier. This is in line with recommendations published by the CNB in October 2017 to mitigate consumer exposure to interest rate risk by offering the option to switch to fixed-rate loans. Box 4.2.3: Affordable and sustainable housing Affordable and quality housing in a safe environment is a fundamental human need and forms part of the UN Sustainable Development Goals. Providing for this need that helps alleviate poverty and social exclusion is still a significant challenge in a number of European countries. Despite suffering from net outmigration, Croatia is experiencing a surge in real house prices in some areas (see Section 4.2.2), with rental prices rising steeply above inflation and GDP growth. These trends make housing less affordable and merit monitoring. Only 5.8% of Croatians live in households that spend 40% or more of their disposable income on housing (European Commission 2019c). This compares favourably to the EU average (10.4%). This could be related to the relatively high proportion of the population living in households with no outstanding mortgage (83.6% compared to 42.8% in the EU). Housing affordability differs considerably in Croatia according to type of household. Despite only 1.5% of Croatians being tenants with market-price rents, almost half of this population’s housing costs exceed 40% of their disposable income. This is considerably higher than the EU average (26.3%) and significantly higher than in Croatia’s neighbouring countries. A very high cost of housing relative to income may lead to housing deprivation, such as living in dwellings that are not adapted to the size of their household or that have serious structural flaws. Croatia has a number of government housing schemes and incentives. 8.0% of Croatians are tenants renting at reduced or no rent. In addition, a government scheme introduced in 2017 subsidises people aged up to 45 years buying a house. However, this subsidy is neither means-tested nor targeted at those areas where affordability is lowest. Ensuring the availability of affordable housing will remain a challenge particularly in some areas. The currency structure of debt has changed as the share of kuna-denominated debt in total household loans continued to rise. In September 2019, 45% of households’ outstanding loans ( ) were denominated in or indexed to a foreign currency, down from a peak of 80% in March 2012. Households hold significant foreign-currency deposits, representing nearly 80% of total outstanding deposits, which, if matched, could significantly mitigate risk. Housing market In 2019 house prices in Croatia experienced double digit growth for the first time since the financial crisis. A favourable macroeconomic environment, with increasing employment and low interest rates fuelled the surge in property prices. House prices started to pick up in step with the rise in mortgages after having fallen for much of the past decade (Graph 4.2.7). House prices rose at an annual average rate of 10.4% in the second quarter of 2019. However, this masks significant regional disparities. House prices in Zagreb surged by 14.5%, well above the rise on the Adriatic coast (9.1%) and in the rest of the country, where prices rose by 3.3%. Housing rents are also increasing. In the year to October 2019, rents increased 5.3%. This is considerable, coming on top of the 2.6% increase in 2018. Rising house prices coupled with steep increases in rents could create affordability issues that merit close monitoring (Box 4.2.1). Despite the surge in property prices, prices are still below peak levels recorded before the financial crisis. Nevertheless, there is currently no sign of overvaluation, given the well-established benchmarks such as price-to-rent ratios, which show that house prices are still below their long-term average in Croatia. Graph 4.2.7:House price (2015=100) and mortgage growth Source: European Commission, ECB Measures to improve the collection of real estate data continue. In August 2019, the European Systemic Risk Board (ESRB) strengthened the data requirements for the assessment and monitoring of risks to financial stability associated with real estate markets. In response, the Croatian National Bank (CNB) is setting up a new system to collect granular data on consumer lending conditions, which will enable the monitoring of risks associated with the residential real estate market. 4.3. Labour market, education and social policies* 4.3.1.Labour market developments Unemployment continued to fall, but labour participation remains very low. At 8.4% in 2018, Croatia’s unemployment rate is at its lowest recorded level and projected to continue falling. The employment rate (20-64) reached 65.2% in 2018, 1.6 percentage points up from the previous year. However, this Social Scoreboard indicator remains among the lowest in the EU. The activity rate (15-64) dropped to 66.3% in 2018, pushing Croatia further down the EU country ranking for this metric. The improvements in the labour market benefited different categories of workers and jobseekers, including the long-term unemployed. However, across all age categories, employment rates are below the EU average, with the biggest gap recorded for older workers (55-64) (Graph 4.3.1).

Graph 4.3.1:Employment rate by age group in Croatia and the EU Source: Eurostat Labour shortages have become more pronounced across sectors. The share of employers reporting labour shortages as measured by the European Business Survey (EBS) has increased substantially. In 2018, 23.5% of employers in the industry, construction and services sectors ( ) reported labour shortages, up from 16.9% in 2017 (Graph 4.3.2). The shortages are most pronounced in the construction sector, where half of the employers (51.3%) reported labour shortages as a factor limiting building activity, while the highest increase between 2018 and 2019 (7.1 percentage points) was recorded in the services sector. In response, targeted scholarships have been made available in vocational secondary schools to support training in 62 occupations in high demand. In addition, the authorities decided to facilitate access to the labour market for foreign workers by significantly increasing the number of work permits in construction, tourism and hospitality for 2018 and 2019, and simplifying the procedure to recognise foreign professionals’ qualifications. Graph 4.3.2:Labour shortages in Croatia as reported by employers, 2008-2019(Q3) Source: Business and Consumer Survey, European Commission. Croatia’s population is shrinking due to the natural decrease and to emigration flows. In 2018, the country’s population was 4.1 million, projected to fall to 3.4 million by 2050. The natural increase rate ( ) has been negative since 2009, as births have fallen by 17% in ten years. The projected increase of the median age of the resident population (from 43.7 in 2018 to 51.3 in 2050) is set to amplify the existing challenges in the labour market and the social protection system. Population decline was also driven by negative net migration flows in 2018, even though the flows seem to have ebbed since 2017. To address the demographic challenge, the authorities have implemented measures aimed at improving the material conditions of young families and their children, including increased maternity benefits and birth grants, as well as subsidies for housing. Graph 4.3.3:Population change (%) by county, 2001-2017 Source: Croatian Bureau of Statistics The less-developed regions in Croatia are experiencing depopulation. Between 2000 and 2017, Croatia lost 5.4% of its overall population, but the picture is very mixed across counties (Graph 4.3.3). Only five counties with large urban centres recorded population growth, whereas nine out of the fourteen counties in continental Croatia saw their population fall by between 10 and 20%. The population of Lika-Senj county dropped by almost one-fifth (18%) to reach 8.5 inhabitants per square km (almost as low as the sparsely populated northern areas of Finland). In eastern Croatia, the five counties in Slavonia and Baranja are experiencing chronic depopulation due to migration, especially of young people, as well as low birth rates. This, combined with high rates of unemployment and inactivity, contributes to the economic stagnation and low growth potential of this part of the country. In 2017, only 51% of the working-age population in Slavonia and Baranja was employed, compared to 61% in the rest of Croatia (World Bank, 2019a). Employment rates differ widely across educational attainment groups. In 2018, the aggregate skills mismatch rate ( ), measured on the basis of the three educational attainment levels (low, medium and high), was high in Croatia, and higher than in 2015 (Graph 4.3.4). In particular, the employment rates of low-skilled workers (37.2% in 2018 vs EU 56.1%) and medium-skilled workers (65.1% vs EU 73.4%) considerably lag behind the rate of high-skilled workers (81.5% vs EU 84.5%). This is compounded by the fact that the composition of the Croatian labour force is skewed towards the medium skilled (62% vs EU 48%), with a lower share of low-skilled (8% vs EU 16%). The low activity rate of the latter group is due to the fact that the older cohort are over-represented in it (the activity rate of low-skilled workers aged 55-64 is 24.7% vs EU 48.2%). As a result, Croatia’s employment rate gap to the EU average is driven by the medium-educated. This indicates the need to tackle all the drivers behind low employment, including the lack of the skills needed on the labour market (across all educational attainment levels), and other factors such as job attractiveness and obstacles to geographic mobility. Future jobs will increase the demand for higher skills and qualifications. Due to technological change, the demand for skills is shifting to higher skills and qualifications. According to CEDEFOP’s (2018) forecast of skills needs up to 2030, 36% of all job openings in Croatia will require high-level qualifications (EU average 43%) over the forecast period. In particular, increases are expected for professionals in teaching, legal, social and cultural areas, business, administration and health. By contrast, the study projects that only 4% of all job openings will require low-level qualifications (EU average 11%), as agricultural and fishery jobs will fall substantially with only a small number of new jobs likely to be created to replace current workers. As regards medium-skilled workers, there is projected to remain a surplus on the supply side. Graph 4.3.4:Relative dispersion of employment rates of different educational attainment groups in the EU Source: Eurostat, own calculations. Implementation of active labour market policy measures has improved, but some concerns remain. In 2018, employment and self-employment subsidies covered the largest share of beneficiaries of active labour market policy measures. Results have been good in terms of increasing employability, including for the long-term unemployed. The youth programme “occupational training for work without commencing employment”, is exceeding the initial coverage targets set by the authorities ( ), though too few jobseekers are starting education or reskilling programmes (Ministry of Labour, 2019). As regards passive support, in 2019 unemployment benefits covered only 23% of unemployed people. This could be due to demanding eligibility conditions, including strict availability-to-work conditions and job-search requirements, and the relatively low level of the benefit (European Commission, 2019d). The outreach to the unemployed and inactive youth is still underdeveloped. The rate of young people not in employment, education or training (NEET) and the youth unemployment rate are fast -decreasing (down to 13.6% and 23.7% in 2018, respectively), but remain well above the EU average. Even though the rate of registration of jobseekers at the Public Employment Service is one of the highest in the EU, measures provided under the Youth Guarantee scheme in 2018 reached only 39% of young people (15-24) with the NEET status. The low and progressive decline in coverage is in part linked to the increasing population of non-registered NEETs (from 4.8% in 2017 to 6% in 2018). Around two thirds of those who received support in 2018 were in employment, education or training six months after the end of the measure ( ), above the EU average of 50.4%. Temporary involuntary work is still prominent in Croatia. The share of temporary workers amongst employees (15-64) is one of the highest in the EU (19.9% vs EU average 14.2% in 2018), of which 86.6% are involuntary temporary workers (EU average 52.8%). Part-time work is not a common practice in Croatia, totalling only 4.9%. The incidence of undeclared work is estimated to remain high. Undeclared work may take the form of partly undeclared pay (envelope wages) and fully undeclared employment. There are various factors contributing to this phenomenon, including the low quality of job offers, also reflected in the high number of discouraged job seekers, and the overall perception of inefficient public institutions and regulatory systems ( ). Measures implemented so far have not yet resulted in effective preventive and penalty mechanisms. The establishment in April 2019 of a centralised State Inspectorate, which took over the inspection role previously carried out by sectoral inspectorates, and the announced preparation of a national programme to combat undeclared work may lead to improvements on this front. 4.3.2.Social protection system Poverty levels in Croatia are falling but remain above the EU average. In 2018, the at-risk-of poverty or social exclusion rate decreased, following improvements in all its sub-indicators, but rem