EUROPEAN COMMISSION Brussels, 22.2.2017 SWD(2017) 76 final COMMISSION STAFF WORKING DOCUMENT Country Report Croatia 2017

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

imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP

2017 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(2017) 90 final}

{SWD(2017) 67 final to SWD(2017) 93 final}







Contents Executive summary1 1.Economic situation and outlook4 2.Progress with country-specific recommendations10 3.Summary of the main findings from the MIP in-depth review13 4.Reform priorities19 4.1.Public finances19 4.2.Private sector debt and financial sector24 4.3.Labour market, social policies and education31 4.4.Business environment and investment39 4.5.Public sector governance48 A.Overview table56 B.MIP Scoreboard61 C.Standard tables62 References67



LIST OF Tables 1.1.Key economic, financial and social indicators — Croatia9 2.1.Summary table on 2016 CSR assessment11

3.1.MIP Matrix17 4.1.1.Tax brackets in PIT (HRK / month)22 4.2.1.Financial soundness indicators, all banks28 B.1.The MIP Scoreboard for Croatia61 C.1.Financial market indicators62 C.2.Labour market and social indicators63 C.3.Labour market and social indicators (continued)64 C.4.Product market performance and policy indicators65 C.5.Green growth66 LIST OF Graphs 1.1.Real GDP growth by demand component4 1.2.Structure of employment (lhs) and unemployment rate (rhs)5 1.3.Contributions to rate of change in yearly unit labour costs (ULC)5 1.4.Current account composition, gross external debt and net international investment position6 1.5.Inflation dynamics and main components in Croatia and in the euro area and money market interest rates6 1.6.Average cost of MFI euro-denominated loans for non-financial corporations, new business7 1.7.Debt and debt servicing burden to GDP for non-financial corporations , households and general government sector7 1.8.Actual and potential output growth8 3.1.Level and change in net international investment position15

4.1.1.General government debt by currency and market of issuance19 4.1.2.Contributions to yearly change in debt to GDP and total debt to GDP20 4.1.3.Expenditure on the wage bill and intermediate consumption compared to peers 201620 4.1.4.Budget revenue from EU grants: projections, revisions and execution 2014-201721 4.1.5.Gross public debt under different scenarios21 4.2.1.Contributions to changes in total corporate debt24 4.2.2.Proportion of debt by risk class and industry (2010 and 2015)25 4.2.3.Currency composition of corporate debt25 4.2.4.Contributions to change in total households debt26 4.2.5.Key indicators of the Croatian banking sector27 4.2.6.Non-performing loans developments28 4.3.1.Change in the unemployment rate: contribution of employment and participation31 4.3.2.Change in activity rate by age and skill level (Q3-2015 and Q3-2016)31 4.3.3.Composition of new retirees by type of pensions32 4.3.4.Temporary employment by labour market status 1 year before, and share of temporary contracts in total employment33 4.4.1.Potential output in Croatia and in Central Eastern European peer economies39 4.4.2.Investment by sectors, cumulative growth41 4.4.3.Investment across sectors: 2009 versus 201541 4.4.4.Sources of investment financing by sectors (2015)42 4.4.5.Productivity in Croatia and CEE peers by industry (2014, CEE total=100)42

4.4.6.Change in average productivity by industry (2010-2014)43 4.4.7.Restrictiveness indicator44 4.4.8.Broadband connectivity in Croatia by speeds (% of households)46 4.5.1.Aggregate local government unit expenditure in 2015 by function48 4.5.2.Municipalities and towns (*) current revenue and expenditure in 2015 by size class49 4.5.3.Productivity gap of SOEs by ownership51 LIST OF Boxes 2.1.Contribution of the EU budget to structural change in Croatia12 4.3.1.Impact of personal income tax reform on inequality and work incentives34 4.4.1.Investment challenges and reforms in Croatia40 Executive summary This report assesses Croatia’s economy in light of the European Commission’s Annual Growth Survey published on 16 November 2016. In the survey, the Commission calls on EU Member States to redouble their efforts on the three elements of the virtuous triangle of economic policy — boosting investment, pursuing structural reforms and ensuring responsible fiscal policies. In so doing, Member States should focus on enhancing social fairness in order to deliver more inclusive growth. At the same time, the Commission published the Alert Mechanism Report (AMR) that initiated the sixth round of the macroeconomic imbalance procedure. The in-depth review, which the 2017 AMR concluded should be undertaken for the Croatian economy, is presented in this report. The recovery picked up steam in 2016. In 2015, GDP had expanded modestly, marking the end of one of the longest and deepest recessions in the EU. The recovery accelerated in 2016, at a projected rate of 2.8 %. An improving labour market, low energy prices and the personal income tax reform spurred consumption. Investment started to finally recover, thanks partly to a pick-up in the use of EU Funds. Croatian goods continued to gain export market shares, while soaring tourist arrivals boosted the export of services. Economic growth is projected to remain robust and broad-based in the short term, and the labour market to improve further. As favourable new developments replace the fading tailwinds that have aided the recovery for the past two years, GDP growth is forecast at a relatively robust 3.1 % in 2017 and 2.5 % in 2018. Consumption is expected to be bolstered by the newly adopted tax reform, with lower personal income taxes more than compensating for the impact of inflation on household disposable income. A further increase in the absorption of EU funds and still favourable credit conditions are set to support investment. Growth of exports is set to moderate, while imports are projected to keep growing, leading to a gradual fall in the current account surplus. The labour market is projected to continue improving, with activity rates stabilising and the unemployment rate declining further. The economic recovery is helping to reduce domestic and external debt, but vulnerabilities persist. Private sector debt reduction is progressing, and the general government debt ratio moved onto a declining path in 2016. External liabilities are contracting, as the current account remains in solid surplus. An overall sound financial sector lays the ground for continued macro-financial stability. Nevertheless, vulnerabilities persist, in particular related to high levels of debt denominated in foreign currency. Modest growth prospects remain a key challenge for the economy. Protractedly slow productivity growth and low and declining utilisation of human capital reduce the economy's long term growth prospects. At about 1 %, Croatia's currently estimated potential growth rate is low compared to other catching up economies. Real GDP has been growing above this rate over the past two years and the economy is projected to keep growing above potential over the forecast period. In the medium term, however, the economy is set to return to its long-term potential. This will slow down the convergence process and the unwinding of macroeconomic imbalances. Improving this long-term scenario will require determination in carrying out structural reforms. Croatia has made limited progress in implementing the 2016 country-specific recommendations, in the context of two general elections in less than a year. Only a few of the policy commitments put forward in the 2016 national reform programme have been implemented to date. Croatia has made limited progress in reinforcing numerical fiscal rules and strengthening the Fiscal Policy Commission, as well as improving budgetary planning and strengthening the multi-annual budgetary framework. Some progress has been made in reforming recurrent property taxation and improving debt management. There has been no progress in discouraging early retirement, accelerating the transition to the higher statutory retirement age and aligning pension provisions for specific categories with the rules of the general scheme. Limited progress has been made in providing appropriate up- and re-skilling measures, while there has been no progress in consolidating social protection benefits. Limited progress has been made in reducing the fragmentation and improving the functional distribution of competencies in the public administration. There has been no progress in harmonising the wage-setting frameworks across the public administration and public service. Limited progress has been made in reinforcing the monitoring of state-owned enterprises’ performance and boards’ accountability, as well as advancing the listing of their shares and the divestment process of state assets. There has been limited progress in reducing parafiscal charges and the administrative burden on businesses, as well as removing unjustified regulatory restrictions on regulated professions. Limited progress has been made in to improving the quality and efficiency of the judicial system in commercial and administrative courts. Finally, there has been some progress in facilitating the resolution of non-performing loans. Regarding progress in reaching the national targets under the Europe 2020 strategy, Croatia’s record is mixed. It is on track in terms of energy efficiency, reducing greenhouse gas emissions, increasing the share of renewable energy (except in transport), reducing early school leaving and reducing poverty and social exclusion. However, this is less the case for targets on tertiary education attainment and employment rates, R&D investment and renewable energy in transport.

The main findings of the in-depth review contained in this report, and the related policy challenges, are as follows: In 2016, the general government debt ratio moved onto a declining path, but sustainability risks have not been fully overcome. After having more than doubled during the six-year recession, the general government debt is expected to have shrunk to 84.1 % of GDP in 2016 and to continue declining in the short term. Several factors contributed to this outcome. They include the achievement of a primary surplus in 2015 and its increase in 2016, declining debt servicing costs, higher GDP and a slight appreciation of the kuna against the euro in 2016, which reduced the value of outstanding government liabilities denominated in foreign currency. However, public debt remains high — well above its pre-crisis levels — and much of it is denominated in foreign currency, and thus exposed to currency risk. Moreover, while sustainability risks are low in the long term, they remain high in the medium term. They are compounded by weaknesses in fiscal governance, including in strategic planning and in the debt management framework. Private sector debt is decreasing, but remains high, especially in the corporate sector, and heavily exposed to currency risk. The pace of corporate and household debt reduction picked up speed in 2015 and 2016. This was due to higher growth as well as the slight appreciation of the national currency towards the euro, as a significant proportion of private debt is also denominated in foreign currency. However, in the corporate sector, debt remains high and concentrated in a few sectors and a handful of companies. The legislated conversion of Swiss franc-denominated household loans also helped reduce household indebtedness in 2016, but resulted in significant losses for the banking sector. The financial sector is set to support the recovery, but remains exposed to indirect credit risk. The financial sector remains well capitalised, despite the losses incurred with the conversion of the Swiss franc loans, and its profitability recovered in the course of 2016. Improving economic conditions and low interest rates are expected to support credit demand. Combined with the improving quality of banks' assets, this is set to result in mildly positive net credit flows. However, the non-performing loans ratio remains high in comparison to other Member States. The new provisions on the treatment of writing off non-performing loans, as part of the tax reform, may give impetus to their swift resolution. The banking sector, nevertheless, remains exposed to indirect credit risks through the large foreign currency exposure of its corporate and household clients. The central bank's tight management of the exchange rate significantly reduces these risks. The unemployment rate is falling rapidly, thanks to moderate job creation but also a shrinking labour force. In 2016, the unemployment rate fell to 12.8 %, over 3.5 percentage points below the rate a year earlier. However, the contracting labour force accounted for more than half of this reduction, while most of the new jobs were created on temporary contracts. Youth and long-term unemployment remain high. Limited availability of attractive job opportunities may have discouraged labour market participation and contributed to increasing migration outflows. Skill gaps among the working age population and multiple pathways to early exit compound the problem. The employment rate remains amongst the lowest in the EU, as early retirement and, for women, care responsibilities, drive a high share of prime-age potential workforce out of the labour market. Despite the low utilisation of the labour potential, the steep decline in the number of jobseekers is expected to give rise to renewed wage pressure, following years of wage moderation. A cumbersome business environment depresses productive investment and productivity growth. Croatia’s productivity growth lags behind that of its central and eastern European peers in all sectors of the economy. The average productivity of Croatian firms has improved in recent years, but inefficient allocation of resources has prevented productive businesses from growing faster than their less productive competitors. Productivity is particularly weak in state-owned enterprises and in heavily regulated sectors such as energy, and to a lesser extent in transport. The high level of the administrative burden in the provision of services and of parafiscal charges continues to constrain investment in business creation and expansion. Furthermore, the regulatory environment for service providers and regulated professions remains restrictive. The difficulties in accessing finance are preventing small and medium-sized enterprises from expanding more rapidly. Other key economic issues analysed in this report which point to particular challenges facing Croatia’s economy are as follows: The fragmented public administration weighs on the effective delivery of public services. Croatia’s marked territorial fragmentation and complex fiscal relations across levels of government are not conducive to an efficient delivery of public services and the reduction of regional disparities. The wage setting framework still lacks consistency across the public administration and public services. Improving the efficiency and quality of the justice system remains a challenge, despite reduced backlogs. Health outcomes remain below EU average. Although the sector continues to generate arrears, no action has been taken to promote a more sustainable and efficient financing of health care. Finally, the new ministry in charge of managing public assets could foster a more coordinated approach and give impetus to restructuring and privatisation. The Croatian Bank for Reconstruction and Development still appears to lack the high standards of transparency and accountability that are needed to fulfil its mission. The education and social protection systems still suffer from structural weaknesses. Lack of basic skills makes transitions into employment difficult. The awaited reform of the education system has been delayed, and efforts to equip the workforce with the skills needed in the labour market remain insufficient. Croatia still exhibits high levels of poverty and social exclusion, and the two successive personal income tax reforms have reduced the tax system's capacity of tackling income inequality. Inconsistencies, fragmented coverage and lack of transparency in the system of social protection weaken its effectiveness and fairness. Finally, both current and future adequacy of pensions is low and creates high risks of poverty in old age, especially for those with shorter working lives. 1. Economic situation and outlook GDP growth Croatia came out of its six year recession in 2015 and a strong recovery is now underway. The 2008 economic and financial crisis has had a profound and long lasting impact on the Croatian economy, as it brought to the fore important structural weaknesses and macroeconomic imbalances accumulated in the pre-crisis years. Between 2008 and 2014, real GDP contracted by more than 12 %. Following EU accession in July 2013, export of goods started to provide a positive contribution to growth, followed, one year later, by the strong rise in the contribution of export of services, especially tourism. As falling energy prices and the income tax cuts implemented in late 2015 boosted household disposable income, 2015 finally saw a return to positive real GDP growth, by 1.6 %. Investment also started to rebound in the course of 2015 and picked up momentum the following year. Overall, in 2016 GDP growth is expected to have accelerated to 2.8 % (see Graph 1.1) while turning broader-based across demand components and sectors. Growth is expected to remain robust until 2018, but the volume of output is set to remain below pre-crisis levels. The favourable conditions that supported the recovery in the last two years are abating. No further significant cost-competitiveness gains are expected as productivity growth remains subdued and wage growth resumes. After three years of sizeable gains, export market shares are projected to gradually stabilise by 2018. As import growth remains robust, net external demand is projected to have detracted from growth in 2016 and continue to do so over the forecast period. At the same time, the recovery of employment and wages and the stipulated reduction in the personal income tax (see Section 4.1) are expected to support consumption, while investment is set to benefit from continued favourable financing conditions and increased absorption of EU funds. Against this background, the Commission 2017 winter forecast expects GDP growth to accelerate to 3.1 % in 2017 and slow down to 2.5 % in 2018. Yet, by 2018 real GDP is projected to remain about 3 % lower than the peak attained in 2008. Graph 1.1:Real GDP growth by demand component Source: Eurostat Labour market The acceleration in output is boosting employment, but job creation has relied mainly on fixed-term contracts. During the crisis, slow wage adjustment exacerbated labour shedding (see Graph 1.2). The unemployment rate peaked at 18 % in mid-2013. In 2013 and 2014, two reforms were implemented to make the labour market — especially the temporary contracts segment — more flexible, while wages started to adjust. Employment began to expand at the end of 2013 ( ). It is projected to have increased by 1.9 % in 2016. Job creation has relied almost exclusively on temporary contracts — also due to the expansion of the seasonal tourism-related industries. Employment growth is expected to strengthen this year and slightly decelerate thereafter. Graph 1.2:Structure of employment (lhs) and unemployment rate (rhs) Source: Eurostat, LFS The unemployment rate has been falling rapidly, partly due to a marked contraction of the labour force, and wages have started growing again. The unemployment rate fell to 12.8 % in 2016. This rapid decrease is only partly due to employment growth. The labour force continued to shrink throughout 2016, also due to net migration outflows. In the third quarter, the activity rate was down to 65.6 % (age group 15-64), some 8 pps below the EU average. No further major declines of the labour force are expected going forward. Consequently, the unemployment rate is set to contract at a more moderate pace, falling to 9.3 % by the end of 2018. The steep decline in the number of jobseekers is contributing to renewed wage pressure. After years of wage moderation, in 2016 wages are expected to have increased by roughly 1.7 %, (i.e. 2.3 % in real terms). In turn, unit labour costs are projected to have started increasing again in 2016, and are forecast to keep growing in line with developments in the euro area (see Graph 1.3). The outcome of the ongoing wage negotiations in the public sector (see Section 5.1) may add wage pressure in the private sector through demonstration effects. Overall, compensation of employees is projected to increase by around 2.5 % in both 2017 and 2018. Graph 1.3:Contributions to rate of change in yearly unit labour costs (ULC) Source: Eurostat, European Commission winter 2017 forecast Social developments

Income inequality has remained broadly stable and close to the EU average since the crisis. In 2014 the richest 20 % of households had 5.3 times more income than the poorest 20 %, broadly in line with the EU average ( ) However, income inequality in Croatia is driven by the poorer households having a lower share of income than in other European countries ( ). Income inequality before taxes and benefits — "market income inequality" — was 66 % higher than after taxes and benefits. This indicates that Croatia's tax-benefit system reduces inequality by around the same extent as the EU average. The tax reforms implemented recently (at the end of 2015 and again on 1st January 2017) are set to slightly weaken the system's redistributive capacity (see Box 4.3.1). Graph 1.4:Current account composition, gross external debt and net international investment position Source: Eurostat, NCB External position As domestic savings continue to outstrip investment, the current account remains in surplus, and external liabilities are abating. After a record deficit of 9 % of GDP in 2008, the current account balance turned into a small surplus position in 2013. The improvement was initially driven by a contraction of imports, but as of 2013 the main driver has been the positive performance of exports of goods and, more recently, services. The surplus has progressively strengthened, reaching a record 5.0 % of GDP in 2015 (see Graph 1.4). As the impact of temporary factors fades-out ( ), export market shares stabilises and oil prices increase again, the current account surplus is expected to shrink to 1.3 % of GDP by 2018. The improvement in the current account balance helped reverse the trend of growing external indebtedness. Net external liabilities improved from the record negative position of about 98 % of GDP in early 2011 to 75.8 % of GDP in mid-2016. Similarly, gross external debt fell from 106 % to 97 % of GDP over the same period. The ratio of external liabilities is set to continue falling in the short term as continued surpluses combine with stronger growth. Inflation and interest rate developments Following two years of deflation, the rebound in energy prices and wage increases is driving a turnaround in price dynamics. In 2015, the collapse in energy prices on international markets fed through to domestic energy prices and contributed to negative inflation, at -0.3 % in 2015 and -0.6 % in 2016. Prices started to increase again towards the end of 2016 and the rising trend is expected to strengthen over the forecast horizon, sustained by a rebound in energy prices (partly offset by VAT cuts) and, to a lesser extent, wage growth. Inflation is therefore projected to rise back to 1.7 % in 2017 and slightly decelerate in 2018, as the recovery in energy prices slows down. Graph 1.5:Inflation dynamics and main components in Croatia and in the euro area and money market interest rates Source: Eurostat The accommodative monetary policy is resulting in lower interest rates, but the spread between the local and euro area rates remains high. The combination of the economic recovery, stronger demand for kuna loans and solid current account surplus has allowed the central bank to pursue an even more expansionary monetary policy. Abundant kuna liquidity was released through several refinancing operations during 2016. Despite the traditionally weak transmission mechanisms of domestic monetary policy, the loan rates for newly granted loans have decreased (see Graph 1.6), more so in the euro segment. However, the spread between the average interest rates on newly granted euro denominated loans to non-financial corporations in Croatia and in the euro area remains high, occasionally surpassing 200 basis points. Graph 1.6:Average cost of MFI euro-denominated loans for non-financial corporations, new business Source: Croatian National Bank, European Central Bank, own calculations Private indebtedness Businesses and households continue to reduce their high debt and foreign currency exposure. During the recession, corporate and household deleveraging progressed slowly, as negative credit flows were partially offset by contracting income. By mid-2016 corporate debt is estimated to have fallen to 72 % of GDP (of which about 55 % is external liabilities and 22 % is domestic debt contracted in foreign currency). Household debt is estimated to have decreased to about 36.5 % of GDP (of which just above 60 % contracted in euros, down from 68 % at the end of 2015) ( ). The recent reduction was largely driven by higher growth, the conversion of Swiss franc loans (which in some cases resulted in accelerated re-payment) and currency-related valuation effects, while the contribution of net credit flows has turned broadly neutral. Easing deleveraging pressures and improving financing conditions are laying the basis for a new credit expansion phase. Debt levels remain relatively high. Yet, the low interest rate environment has reduced the debt servicing burden for households and firms (defined as interest paid to GDP ratio), as most loans to households are on flexible interest rates and corporate debt has been rolled-over on more favourable terms. This, combined with the acceleration of economic activity, is expected to stimulate credit demand. After peaking at 17.3 % in mid-2015, the proportion of non-performing loans fell below 15 % in mid-2016, due to a large extent to accelerated sales and write-offs of impaired assets. The freeing-up of reserves and abundant kuna liquidity are set to ease supply constraints. Credit is therefore projected to resume expanding already in 2017. Currency and maturity mismatches between new credit demand (long-term kuna) and deposits (short-term kuna or long-term EUR) may nevertheless turn out to be a limiting factor, if households maintain their preference for foreign currency deposits. Graph 1.7:Debt and debt servicing burden to GDP for non-financial corporations , households and general government sector Source: European Commission, DG ECFIN Public finances Public finances deteriorated substantially during the recession, but as of 2016 the general government debt ratio is set to decline. During the crisis, the accumulation of high deficits and transactions related to state-owned enterprises (SOEs) were the main drivers of general government debt. Budgetary targets set through the excessive deficit procedure (EDP) have provided an anchor to fiscal policy. After hitting a record high of 7.8 % of GDP in 2011, the deficit contracted to 3.3 % of GDP in 2015 and is expected to have reached 1.8 % of GDP in 2016. The combination of these factors with the more benign growth outlook is expected to have put the public debt to GDP ratio onto a declining path. The ratio is projected to have declined to 84.1 % in 2016 and to shrink further to 81.3 % in 2018. Potential growth The sustainability of the adjustment process rests on lifting the low potential growth. The rebound in internal demand is driving GDP above its potential growth rate. In the medium term, however, output growth is set to revert to its potential, which is currently estimated at around 1 %. The on-going recovery of capital expenditure is lifting the long term growth outlook, but it will take years of sustained investment growth before the contribution of capital deepening to potential GDP growth returns to pre-crisis levels. Moreover, adverse developments in the labour force and subdued total factor productivity (TFP) still limit Croatia's long term growth prospects (see Graph 1.8). A pre-condition for the abatement of accumulated domestic and external debt largely relies on a prolonged period of sustained growth. This, in turn, hinges upon the implementation of structural policies to lift TFP growth and increase the utilisation of labour potential. Graph 1.8:Actual and potential output growth Source: European Commission, DG ECFIN

Table 1.1:Key economic, financial and social indicators — Croatia Source: European Commission, ECB

2. Progress with country-specific recommendations Progress with implementing the recommendations addressed to Croatia in 2016 ( ) has to be seen as part of a process which started with the introduction of the European Semester. Most country-specific recommendations have remained unchanged since 2014 when Croatia was first included in the European Semester cycles. The most notable areas of progress have been ensuring a lasting correction of the excessive deficit and reducing the general government debt ratio. The general government deficit shrank markedly in 2016, although this owed more to windfall gains and under-execution of expenditure than to structural consolidation measures that would ensure sustained fiscal discipline. Measures to improve the fiscal framework are still pending, while a public debt management strategy was adopted in January 2017. In 2014 Croatia implemented reforms to make the labour market more flexible, but weaknesses in the pension and social protection system have not been addressed. Two reforms were implemented in order to enhance the flexibility of the labour market. The quality of services offered by the Croatian employment service was improved and active labour market policy measures were re-designed with a focus towards the young without working experience, including those who are not in employment, education or training. The comprehensive reform of the education system is being reassessed and its implementation is delayed. The authorities adopted a plan for reforming the vocational education system that should improve the quality and relevance of education for the labour market. However, the challenge of low labour utilisation has still not received an adequate response, as measures encouraging longer working lives and a streamlining of pension provisions have not yet been carried out. On the positive side, the assessment of disability claims was harmonised and moved to a new Single Expert Evaluation Body. Finally, weaknesses in the social protection system have not been addressed. Policy actions aimed at improving the business environment and the public administration have been largely delayed. This includes the main pillars of the public administration reform and the law on public sector wages, now planned for 2019. Several para-fiscal charges were abolished or reduced and an action plan to reduce the administrative burden was adopted. The management of public assets was transferred to a newly established ministry. The divestment of state-owned companies has not proceeded in line with the announced plans, and the adoption of the corporate governance code has been delayed.

Reforms of healthcare and EU funds absorption have progressed slowly, while steps have been taken to improve the judiciary system. There was limited progress in implementing structural measures in the healthcare sector and addressing the accumulation of arrears. The absorption of EU funds remains hindered by limited administrative capacity and strategic planning. Insolvency procedures have been thoroughly revised, and the reformed judicial map has improved the efficiency of the system. However, the quality and efficiency of the judiciary continue to pose challenges, with large backlogs and long disposition times. Implementation of the recommendations on the financial sector came with some drawbacks. In 2014, the comprehensive portfolio screening of the banking sector confirmed its robustness, and the some identified weaknesses have been addressed. The share of non-performing loans remains relatively high, but they are well provisioned, and their sale has accelerated lately. The conversion of Swiss franc loans into euros hit the profitability of the banking sector, and may have damaged legal certainty. Overall, Croatia has made limited ( ) progress in addressing the 2016 recommendations. In the context of two parliamentary elections in less than one year, Croatia undertook limited policy action. There has been some progress with public debt management and the introduction of a simple form of recurrent property taxation, envisaged as of 2018. Furthermore, the 2017 tax reform included provisions on tax deductibility for writing off non-performing loans, which is expected to help banks improve their asset quality. Table 2.1:Summary table on 2016 CSR assessment Source: European Commission 3. Summary of the main findings from the MIP in-depth review The 2017 Alert Mechanism Report called for a new in-depth analysis to monitor progress in unwinding the excessive imbalances identified in previous years. In March 2016 the Commission concluded that Croatia was experiencing excessive macroeconomic imbalances and called for a new in-depth review to examine further the persistence of macroeconomic risks and to monitor its progress in unwinding excessive imbalances. These are mainly related to the high levels of external and domestic debt, both largely denominated in foreign currency, in a context of low potential output growth. This report provides the in-depth review of how the identified imbalances have developed. Analysis relevant to the review is found in the following sections: government debt is analysed in section 4.1; private sector debt and the financial sector are discussed in section 4.2; labour market is analysed in section 4.3; business environment and investment, and public sector governance — all issues relevant to addressing the low productivity growth — are discussed in chapters 4.4 and 4.5 respectively. 3.1.Imbalances and their gravity After 6 years of rapid increase, general government debt is projected to have shrunk to 84.1 % of GDP in 2016. Long-term debt sustainability challenges are considered manageable, but vulnerability remains substantial in the medium term. The debt ratio has diminished in the last year, but it does not decrease under all envisaged scenarios and debt levels are likely to remain high in the coming years. Moreover, a large share of the public debt is exposed to currency risks. This concerns both the part of public debt held by foreign investors (35 % of GDP) and the domestic debt denominated or indexed in EUR (37 % of GDP). Private sector debt is projected to have shrunk to 115 % of GDP by mid-2016, but it remains heavily exposed to currency risks. A number of sectors (notably construction) appear over-indebted. More than half of corporate debt is cross-border lending, thus subject to currency risk. On the other hand, part of cross-border debt (about 13% of GDP in 2015) consists in inter-company loans, typically less exposed to re-financing risks. Moreover, at least 18% of the remaining domestic corporate debt is also exposed to currency risks. While household debt stood at a moderate 36.5% of GDP by mid-2016, more than half of it was contracted domestically but in foreign currency, mostly euros. The financial system has withstood the financial crisis and the rapid accumulation of non-performing loans, but remains exposed to the credit risks of its unhedged borrowers. By September 2016, the share of non-performing loans remained at 14.7 % but impaired assets were well covered. Direct exposure of the financial sector to currency risk was limited, although the largely unhedged foreign currency exposure of its household and corporate clients represents a source of vulnerability. The tight management of the exchange rate has been successful in managing these risks. High corporate and government debt are reflected in a high level of external debt and a negative net international investment position. The excess of investment over domestic savings has resulted in the accumulation of sizeable external liabilities. However, by mid-2016 gross external debt had shrunk to about 97 % of GDP, while the net international investment position stood at 75 % of GDP. Risks related to the high share of external liabilities are mitigated by the significant share of inter-company lending; on the other hand almost one third of external debt is in the form of government securities. Potential output growth remains low due to weak labour utilisation and subdued growth in productivity. At the end of 2015, the participation rate of 66.8 % (age group 15-65) was one of the lowest in the EU. This is mostly due to low activity rates among prime-age men. In spite of the low participation, the unemployment rate was still high at 16.5 %, particularly for young people (43 % in the age bracket 15 to 24) and for the low skilled (22.8 %). Productivity (measured as total factor productivity, TFP) has contributed negatively to growth over the past 6 years, but it was registering rather sluggish growth rates even before the crisis. Adverse productivity developments are rooted in weak business environment and public sector governance, which prevent a more efficient allocation of resources throughout the economy. Croatia’s low potential growth is slowing the resolution of stock imbalances and amplifying related vulnerabilities.

3.2.Evolution, prospects, and policy responses The general government deficit is projected to have shrunk further in 2016, while the debt-to-GDP ratio has moved onto a declining path. In 2015, Croatia significantly cut the headline deficit. The strengthening of the recovery in 2016 resulted in windfall revenue gains which, together with contained expenditure growth, resulted in a projected headline deficit of just above 2 %. This lower deficit, combined with the acceleration of growth and exchange rate-related valuation effects, is projected to have led to a slight decline in the debt-to-GDP ratio to 84.1 %. This trend is expected to continue thanks to the improved macroeconomic situation. Moreover, the current low interest rate environment is lowering refinancing costs. Vulnerabilities linked to the high currency exposure of public debt remain. The debt sustainability analysis reveals that short and long term sustainability risks are low, but the medium-term risk is high, albeit with some improvements since 2015. The outlook of the sovereign credit rating has improved, but retains a non-investment grade. The recently adopted tax reform will boost investment and consumption, but will also result in a deterioration of the public finances. The reform lowers the corporate and personal tax rates and aims to simplify procedures and modernise the tax administration. The expected direct budgetary effect of the reform is a revenue reduction of 0.6 % of GDP in 2017 and an additional 0.2 % in 2018. The reform is expected to have a positive impact on consumption and investment, but is not targeted at low income households, nor at making work pay for the low skilled. Household deleveraging picked up steam in 2016 on the back of higher growth, valuation effects and the legislated conversion of the Swiss franc mortgage loans. By mid-2016 the household debt was estimated to have further contracted by some 2.5 pps of GDP. The impact of transactions turned broadly neutral due to a slight pick-up in kuna loans. The strong growth performance in the first half of the year also contributed to the acceleration of deleveraging. The main driver, nevertheless, was the reduction in debt owed to credit institutions arising from the statutory conversion of Swiss franc-indexed loans to euro-denominated loans. The impact on banks' balance sheets was estimated at roughly 2.3 % of GDP up to the first quarter of 2016 (see below), but this figure also includes the sale of non-performing loans. The impact on household debt is therefore lower. The appreciation of the kuna exchange rate also helped households with euro denominated debt by reducing the value of their outstanding liabilities. The total indebtedness of the non-financial corporate sector continued to decline in the first half of 2016. By mid-2016, consolidated corporate debt is estimated to have further contracted by around 2.5 pps of GDP. The contribution of transactions was broadly neutral. Valuation effects, largely driven by the appreciation of the kuna against the euro played a significant role, but the bulk of the reduction was delivered by the acceleration of growth. The reduction in external debt, partly driven by debt-to-equity swaps was the main driver of the reduction in indebtedness. In the current low interest rate environment, the repayment burden has eased considerably. Exposure to exchange rate fluctuations nevertheless remains high as external debt still amounts to 39.8 % of GDP and domestic debt contracted in foreign currency amounts to at least 16.2 % of GDP. In 2015, banks’ profitability was severely affected by the conversion of Swiss franc loans, but it has now recovered. The aforementioned conversion of the Swiss franc loans resulted in bank losses that are estimated at HRK 7.6 billion (or 2.3% of GDP). The banks nevertheless remained well capitalised and the quality of their assets is improving. Overall, proportion of non-performing loans fell to below 15% by Q3-2016, the lowest in 3 years. Accelerated sale, also motivated by the progressive automatic provisioning imposed by the Central Bank, is the key driver behind this sharp reduction. The tax reform includes provisions on tax treatment of writing off such loans, and this may help improve the quality of banks’ assets further. The amended corporate and personal insolvency frameworks are starting to deliver results, but in the absence of an adequate monitoring system it is difficult to quantify to which extent they are contributing to the deleveraging process. The simultaneous deleveraging of households, government and businesses is resulting in large current account surpluses and the progressive reduction of external liabilities. The current account is set to deteriorate slightly in 2016 due to a surge in profits in the largely foreign-owned banking sector, while still maintaining a solid surplus (2.8 % of GDP). By mid-2016, the external debt had decreased by about 6.5 % of GDP. The deleveraging was mainly intermediated by the financial sector, but was also driven by the direct external deleveraging of the government and the corporate sector. The valuation effects mentioned above, largely related to the appreciation of the kuna, reduced the value of the outstanding liabilities. These improvements carried over to the net international investment position, which improved by a broadly similar magnitude. The net international investment position to GDP ratio nevertheless remains far more negative than the prudential threshold level (-35 % of GDP). Unemployment has declined sharply, although mostly due to the shrinking labour force. In the fourth quarter of 2016, the unemployment rate fell to 11.4 %, from 15.6 % in the previous year. Whereas job creation intensified, more than half of the contribution to this decline came from a further contraction of the labour force caused by adverse demographic dynamics, reduced activity and net migration outflows. The contribution of total factor productivity to potential growth has turned slightly positive in 2016, but market inefficiencies still constrain Croatia’s potential growth. On average, firms are improving their productivity, but the gap with regional peers remains wide in almost all sectors of the economy. The main difference is related to poor allocative efficiency, as the less productive firms appear to be growing faster than the more productive ones. Excessive red tape, sector-specific bottlenecks and limited access to finance for small firms constrain the free flow of labour and capital to where they could be used most efficiently. Graph 3.1:Level and change in net international investment position Source: CNB, Eurostat Structural reforms are needed to tackle the bottlenecks in productivity growth, but the reform agenda has broadly stalled. The withdrawal of parliamentary support to the government in the summer 2016 was followed by a new general election in September 2016. This prolonged the standstill in reforms that started in the run-up to the parliamentary elections of November 2015. As a result, few of the ambitious policy commitments put forward in the national reform programme submitted by the Croatian authorities in April 2016 have been implemented to date. The new government has yet to present a detailed structural reform programme. 3.3.Overall assessment The unwinding of debt related sources of imbalances is accelerating on the back of stronger economic growth, but vulnerabilities persist. Robust growth in 2016 is helping the deleveraging and both public and private debt is now on a declining path. As a large share of the debt is denominated in foreign currency, the kuna's ongoing appreciation is also reducing the value of the outstanding liabilities. The simultaneous deleveraging of the private and public sector is reducing external liabilities and improving the net international investment position. Whereas valuation effects are currently helping the deleveraging process, they also point to the economy’s sensitivity to exchange rate fluctuations. This reinforces the need for the central bank to pursue its policy of tightly managing the exchange rate. It also calls for policies aimed at maintaining the regained competitiveness, while avoiding macro and fiscal measures that could undermine the current account balance. The financial sector is well capitalised and the quality of banks’ assets is improving, but exposure to indirect credit risk remains. Banks are accelerating the resolution of impaired assets, and improving the quality of their portfolios. Profitability indicators are also improving. The financial sector remains indirectly exposed to currency risk due to loans contracted in foreign currency in the household and corporate sector. The indirect risks are mitigated by the tightly managed rate of the kuna against the euro. In the long run the resolution of stock-related imbalances is threatened by the low potential growth. A lasting adjustment, however, requires a prolonged period of sustained economic growth. Growth is projected to remain robust over the forecast period, at well above the economy’s current potential. In the long run, however, maintaining current growth rates will require the root causes of the low growth potential — namely the shrinking labour force and sluggish productivity growth — to be tackled. Progress with implementing growth enhancing structural reforms has been limited. The core of Country Specific Recommendations addressed to Croatia was aimed at boosting employment and productivity by removing disincentives to labour supply and improving the business environment. As discussed in the previous section, there has been only limited progress in implementing the policies. Resuming the reform agenda will be key to ensure a durable adjustment of debt-related imbalances. Table 3.1:MIP Matrix (Continued on the next page) Table (continued) Source: European Commission 4. Reform priorities

4.1. Public finances Until 2015, widening general government deficits led to a substantial increase in the stock of public debt. With cyclically-adjusted deficits averaging above 5 % of GDP in the period 2004-2009, Croatia entered the recession with limited room for fiscal manoeuvre. The protracted recession depressed revenue collection, which resulted in soaring deficits in the period 2009-2014. In addition to deficits in the state budget, public debt was significantly affected by off-budget transactions, including the rising net borrowing of SOEs classified in the general government sector and the take-up of debt by the state upon repeated calls on guarantees to public corporations (together averaging 1.4 % of GDP annually in this period) (European Commission, 2016, p. 14). As a result, general government debt rose from 39.6 % in 2008 to 86.7 % of GDP in 2015. The increase in debt contributed to a build-up of foreign currency exposure. Against the background of limited absorption of debt by the domestic market, almost 40 % of the debt that was accumulated during the crisis was issued abroad. Furthermore, the most of the general government debt held domestically was issued in or indexed to the euro, reflecting the high euroisation of the economy. This resulted in growing exposure of public finances to foreign exchange risks. The general government deficit decreased markedly in 2015-2016 on the back of strong economic growth and expenditure restraint. Between 2014 and 2015, the general government deficit decreased from 5.4 % to 3.3 % of GDP and, according to the Commission's 2017 winter forecast, improved further to 1.8 % of GDP in 2016. The deficit reduction was achieved through a combination of windfall revenues stemming from stronger-than-expected economic growth and expenditure restraint facilitated by the presence of caretaker governments with no legislative powers during much of the year. The restraint no longer affected public investment. On the contrary, backed by a stronger uptake of EU funds (estimated at +20 %), public investment rebounded by an estimated 16 % after it was heavily cut in 2010 (by almost 40%) in an effort to contain soaring public spending, and increasing only moderately thereafter. Graph 4.1.1:General government debt by currency and market of issuance Source: Croatian National Bank, European Commission The reduction in deficit and strong growth drove the debt ratio to decrease for the first time since 2007. In addition to low deficits, which reduced the need to issue new debt, strong GDP growth helped decrease the debt ratio through a denominator effect. Furthermore, the aforementioned high exposure of Croatia's public debt to the euro had a positive effect, as the appreciation of the kuna (slightly above 1 %, from end-2015 to end-2016), also supported the reduction of the debt ratio (by an estimated 0.7 % of GDP in 2016) (see Graph 4.1.2). Thus, general government debt is estimated to have decreased to 84.1 % of GDP in 2016 and is projected to decline further to 81.3 % of GDP by 2018. The structure of public expenditure does not provide sufficient support to growth and jobs. A comparatively high intermediate consumption and wage bill add up to almost one fifth of the country's GDP, which makes the functioning of the government costly in comparison to comparable countries in the region, as well as the EU average (see Graph 4.1.3). Considering in addition the still high costs of debt servicing, this leaves little fiscal space to finance productive investment, education or social spending, which is facing demographic pressures. Therefore, improving the efficiency of spending through structural measures remains a challenge for fiscal policy in the near term. Graph 4.1.2:Contributions to yearly change in debt to GDP and total debt to GDP Source: Eurostat, CNB and Winter Forecast The medium term budgetary framework is expected to be strengthened soon, while the credibility of budgetary targets varies across items. The new fiscal responsibility act should soon be adopted. It is intended to transpose the EU Directive on requirements for budgetary frameworks of the Member States (Council, 2011), including the strengthening of the autonomy and role of the Fiscal Policy Commission. The adoption of a new budget act is also expected, with the aim of making the budgetary framework of the central and local government more binding, namely by qualifying the conditions under which a departure from the set deficit target is permitted. This is set to help reduce the frequency and significance of the revisions to the targets throughout the year that was observed in the past. Still, in order to enhance the robustness of annual and multiannual budgetary planning and execution, ensuring the quality of the underlying projections remain important pre-requisites. In 2015 and 2016, the growth surprise explains much of the discrepancies between projections and execution on the revenue side. However, budgetary projections for items like corporate income tax revenues (underestimated by 16 %) and dividends from entities within the public sector could be improved. Revenues from EU grants are continuously over-estimated (see Graph 4.1.4), although this does in principle not pose a risk for the deficit as they tend to be matched by a similar overestimation on the expenditure side. Graph 4.1.3:Expenditure on the wage bill and intermediate consumption compared to peers 2016 Source: Eurostat, European Commission winter forecast The expansionary 2017 state budget relies on strong take-up of EU funds. In spite of strong growth, the budget projects modest growth in tax revenues (ca. 1.5 %), largely due to the negative impact of the tax reform, estimated at HRK 2 bn in 2017 (this represents 0.6 % of GDP or 2.8 % of 2016 tax revenues). Meanwhile, the budgeted expenditure - net of increases in transfers from the central to the local government to compensate for loss in shared personal income tax revenue resulting from the tax reform - is planned to increase by 6 %. Approximately half of the projected increase is expected to be deficit-neutral as it is intended to be conditional upon financing from external sources (largely EU funds). The wage bill is set to grow by 3.7 % as the terms of the collective agreement were renegotiated with a part of public sector employees. Intermediate consumption is also projected to grow substantially (ca. 14 %), although much of the projected increase should be deficit-neutral as it is projected to be financed from EU funds. Sources of risk to the budget include the estimation of the impact of the tax reform and a further increase in the wage bill resulting from the possible renegotiation of the collective agreement with the rest of the employees in the public sector. The coverage of the state budget was expanded to include two more agencies, with a minor and largely equal impact on both revenue and expenditure. This is welcome as it brings the coverage closer to that of central government in ESA 2010 terms. Nevertheless, the budget still does not feature an ESA-based target (neither for the central government nor for the general government as a whole). Graph 4.1.4:Budget revenue from EU grants: projections, revisions and execution 2014-2017 Source: Official gazette, European Commission estimate (for 2016 execution) Refinancing risks in the short term appear low. Although public debt moved onto a declining path in 2016, at a projected 84.1 % of GDP it still represents a vulnerability for the Croatian economy. The government borrowing requirements were met without major difficulties in 2016, partly thanks to ample liquidity in the financial sector coupled with the current low interest rate environment. Overall, short-term fiscal risks stemming from the fiscal and broader macro-financial conditions in Croatia have significantly decreased since the aftermath of the crisis, and appear now contained. Similarly, two of the leading rating agencies have recently improved the outlook for Croatia's sovereign credit rating, which might imply lower financing costs in the near future. However, with refinancing needs due to maturing debt being higher in 2017, risks may increase if the interest rate and exchange rate environment becomes more adverse. Graph 4.1.5:Gross public debt under different scenarios Source: European Commission Croatia’s fiscal sustainability risk is expected to remain high in the medium term. The improved budgetary position implies that the improvement in the structural primary balance over 2019-2023 needed to reduce the debt-to-GDP ratio to 60 % of GDP by 2031 has significantly declined (from a cumulative 4.5 % of GDP last year to 3.2 % of GDP). However, sensitivity analysis of the public debt trajectory under alternative scenarios (see Graph 4.1.5) still points to high sustainability risks in the medium term. Based on the Commission's 2017 winter forecast, and under normal economic conditions with no change of fiscal policy after the forecast period, the public debt ratio is projected to fall until 2018 but start increasing again after that, reaching 93 % of GDP in 2027. Assuming full compliance with the fiscal effort recommended by the Council and achievement of Croatia’s medium-term objective of a structural balance of -1.75 % thereafter, the debt ratio would continue falling, to 78.5 % of GDP in 2027. By contrast, under more unfavourable assumptions on interest rates and exchange rates, the debt ratio would increase to over 90 % of GDP, which is the critical threshold for considering a certain scenario to be high risk. Currency risk exposure is mitigated by the monetary policy implemented by the Croatian National Bank (Graph 4.1.1). The large share of public debt that is indexed or denominated in foreign currency – mostly euros - implies substantial currency risk, as was also demonstrated by its materialisation in 2016, when the slight appreciation of the kuna against the euro helped reduce the debt-to-GDP ratio (see above). In a simulation which assumes that the kuna depreciates against the euro in 2017 and 2018, public debt would rise to 101.2 % of GDP in 2027. However, exchange rate risk is greatly mitigated by the central bank's tightly managed float of the kuna's exchange rate against the euro. In the long run, in an unchanged policy setting, Croatia faces low fiscal sustainability risk. A still unfavourable initial budgetary position and the projected increase in healthcare costs are more than offset by a substantial projected drop in pension spending as a result of previous reforms. These include the introduction in 2002 of a mandatory fully funded pillar, which is not included in the projections. However, the pension system gives rise to strong adequacy concerns (see Section 4.3.3), which make it susceptible to policy reversals. The authorities have finally adopted a public debt management strategy for the period 2017-19, but the debt management framework has not been strengthened. The government’s high financing needs and the high exposure of sovereign debt to currency risk highlight the importance of developing and maintaining reliable financing sources that are subject to prudent risk management. After a gap of three years from the last strategy (which covered the period 2011-2013), a new strategy for the management of public debt over the next three years was adopted in January 2017. It focuses on the debt of the state sector only, thus excluding the financing needs of extra-budgetary entities and local governments. The former have contributed to a large extent to the build-up of debt in past years. In the meantime though, no steps have been taken to reinforce the framework for debt management or strengthen the debt management function within the Ministry of Finance. A comprehensive tax reform has just entered into force. The tax reform package includes several elements, namely a simplification and a reduction in personal income tax (PIT), a rationalisation of corporate income tax (CIT), a one-off incentive for the writing-off of non-performing loans, changes in the VAT categories and the basis for the future introduction of the recurrent property taxation. The personal income tax reform further narrows the tax base. As described in Table 4.1.1, the brackets of the personal income tax (PIT) were reduced from three (12%, 25%, 40%) to two (24% and 36%) and the personal allowance was significantly increased (from a threshold of HRK 2 600 to HRK 3 800). Other changes in the PIT include a more progressive scale for expanding the personal allowance for dependent children and the narrowing of eligibility criteria for other supported family members. Social security contributions for “other income” – i.e. non regular income from employment and self-employment – have also been cut. As a consequence, the number of persons that will no longer pay any PIT will increase by 560 000, reaching 1.5 million (more than half of all persons with income), while higher-income earners will face a significantly lower tax liability (further discussed in box 4.3.1). According to the authorities, the PIT reform reduces tax revenue by 0.4 % of GDP in 2017 (which represents the bulk of the overall effect of the reform of -0.6 % of GDP) and somewhat increases income inequality (see Chapter 4.3). The budgetary impact of the cuts in social security contributions is expected to be marginal, as they apply only to second incomes, which represents less than 2 % of employment and self-employment income.

Table 4.1.1:Tax brackets in PIT (HRK / month) Source: Ministry of finance Reductions in the corporate income tax rates are designed to be broadly compensated by the abolition of costly exemptions and tax breaks. The general CIT rate was cut from 20 % to 18 % and a new, reduced rate of 12 % was introduced for small businesses and farmers (with revenue up to HRK 3m). At the same time, the authorities broadened the base by removing some of the exemptions applied to companies in supported (underdeveloped) geographical areas and by abolishing the tax break for reinvested earnings. This tax break was introduced in 2012 to help revive plummeting investment, against the background of negative credit growth and slow deleveraging. However, as circumstances improved and the design of the tax break was changed, it became costly to implement, while providing benefits to few companies. Reducing rates while simultaneously abolishing the tax breaks and exemptions is expected to result in a broader-based freeing up of investment capital at a cost for the budget of just above 0.1 % of GDP, accompanied by a simplification of the framework. Additional simplifications include the possibility given to small businesses to choose between two methods for calculating their CIT liabilities and the introduction of a system of warnings and recommendations instead of punitive measures for minor offences. However, the substantial gap between the general and the reduced rate (6 pp.) risks creating disincentives for companies to grow. VAT rates remained unchanged, but categories of goods and services were shifted across rates. In a move to support small farmers and households, the reduced rate of 13 % is now being applied to inputs in agriculture, electricity and utility services. On the other hand, food and drink services were moved from the reduced to the general rate. In 2018, the authorities plan to raise the threshold for entry into the VAT system by 30 % and reintroduce a deduction of input tax on vehicles at a rate of 50 %. The authorities estimate the net effect of these measures on budget revenues at around −0.1 % of GDP in 2017 and an additional −0.1 % of GDP in 2018. If this VAT reform translates into lower prices of electricity and inputs in agriculture, the purchasing power of households and the competitiveness of small farmers and businesses will be supported. The introduction of a recurrent property tax is scheduled for 2018, while the property transfer tax rate is being reduced. The authorities remain committed to introducing a recurrent property tax as laid out in the 2016 national reform programme. This long process is envisaged to result in the introduction of a simple property tax first (in 2018) and then a value-based property tax in 2020. The simple version of the tax will entail an enhanced version of the existing utility fee and will also replace the tax on holiday homes as well as one parafiscal charge (the monument fee). The calculation of the tax base will be the same as for the utility fee, with the addition of two new coefficients (age and condition of property, respectively). Exemptions that are in place will be abolished. Local government units will be responsible for providing data on the coefficients. The first stage of this process is progressing well, with 96 % of local government units having conducted the necessary recording of properties by November 2016. The real estate transfer tax rate was cut from 5 % to 4 %, with the entire amount now earmarked for local government units (compared to 80 % before). 4.2. Private sector debt and financial sector A sizeable part of private debt is largely financed externally and in foreign currency. In the run-up to the crisis, the excess of investments over domestic savings was partly financed through direct external borrowing by large corporations, including inter-company lending, and via the financial sector. The resulting surge in domestic bank lending was also partially financed from abroad, so that external indebtedness grew rapidly ( ). In 2010, corporate debt peaked at 83.2 % of GDP, while household debt stood at 42.0 % of GDP. In addition, a substantial part of the domestic lending took place also in foreign currency, amplifying exposure to currency risk ( ). Deleveraging of the private sector has gained momentum, while the financial sector remains robust. In 2016 the overall level of private debt is expected to have declined markedly. Household deposits continued increasing and disposable income grew as well. Benefiting from the improved economic conditions, corporate sector profitability has recovered and investment credit demand has started to increase. The financial sector recovered the profitability that had been dented by the conversion of Swiss franc-denominated loans, and it remains well capitalised, liquid and stable. 4.2.1.Corporate debt High investment rates in the pre-crisis years resulted in a steep accumulation of corporate debt. With investment growing at an average rate of over 10 % between 2002 and 2008, the aggregate indebtedness of non-financial corporations rose sharply up to 2010. Partly because of supply constraints, Croatian corporations often by-passed the domestic banking sector to obtain cross-border loans directly from foreign banks and, to a lesser extent, from parent companies. In 2010, more than 50 % of the of non-financial corporations' total debt was external debt, mostly in euro area countries. Moreover, two thirds of domestic debt was also denominated in foreign currency, essentially the euro. Graph 4.2.1:Contributions to changes in total corporate debt Source: European Commission (Eurostat) Corporate debt has decreased by approximately 7 percentage points between 2010 and 2015. The reduction stemmed mostly from reduced investment. As net credit flows turned negative, by 2015 the debt-to-GDP ratio was down to 75.8 %, while corporate external debt fell to around 42.5 %. The ratio is projected to have further decreased by about 2.5 pps by mid-2016. This is a result of the acceleration of economic activity, but also of valuation effects, as a slight appreciation of the kuna reduced the value of outstanding debt denominated in euro. The deleveraging process went hand in hand with reallocation of resources across industries. Whereas the stock of debt decreased in aggregate terms, evidence from corporates’ balance sheets suggests that the distribution of debt also shifted across industries. Between 2010 and 2015, agriculture, manufacturing, transportation and storage, and accommodation and food increased their proportion of total debt. These dynamics are consistent with the evidence showing that in the recession productive resources shifted towards sectors that are more exposed to external demand. Conversely, the proportion of debt decreased sharply in the wholesale and retail sector and utilities. An increased proportion of debt in the already highly indebted construction sector can probably be related to the persistent involvement of domestic banks in real estate lending, expecting that the real estate market will eventually recover. Graph 4.2.2:Proportion of debt by risk class and industry (2010 and 2015) Source: Orbis, European Commission The sustainability of corporate debt keeps improving, but risks are concentrated in a few sectors and a handful of companies. Between 2010 and 2015, the share of corporate debt considered high-risk decreased from 39% to 31% ( ). This improved risk profile is essentially linked to higher profits, which led to a significant reduction in the debt-to-earnings ratio — one of the key metrics for assessing debt sustainability. High-risk debt nevertheless remains highly concentrated in a few sectors — including utilities (NACE codes D&E), and services other than retail and wholesale (NACE codes M-S) ( ). The absolute level of high-risk debt in the construction sector remains high but the average has recently been decreasing, reaching 27 %. However, the risk profile of debt in construction and the real estate sector may be underestimated to the extent that the stock of unsold properties might still be valued at pre-crisis prices ( ). Furthermore, debt in the construction sector has become more concentrated than before the crisis since the total number of construction firms fell by about a quarter during the recession. Graph 4.2.3:Currency composition of corporate debt Source: Croatian National Bank, European Commission (use of stat) Whereas the stock of corporate debt appears moderate, exposure to currency risk remains high. Despite an increase in domestic currency lending, over 85% of corporate debt (total external debt and part of domestic debt) is denominated in foreign currency. Importantly, the stability of the foreign exchange rate reduces the risk of currency shock. Risks are also mitigated by the currency matching of revenue and expenditure flows in companies operating in the tradable sector. Nevertheless, some non-tradable industries (such as construction) have a higher-than-average currency mismatch (Croatian National Bank, 2015a, p. 32). Exposure to interest rate risk is mitigated by longer debt maturities and the share of contracted fixed interest rates. Although the likelihood of shocks appears low in the current context, the assessed impact is substantial and requires close monitoring. 4.2.2.Household debt A housing boom and expectations of rapid convergence of income levels with the EU average fuelled the past household debt surge. Between 2002 and 2008, real household disposable income increased by 20% underpinned by dynamic wage growth and a strong expansion in employment. Real estate prices soared while expectations of income convergence fuelled demand for durable goods. The prospect of high returns invited the banks — mostly foreign –owned — to increase the supply of credit — including in foreign currency. As a result, household indebtedness reached 42 % of GDP by 2010 – still low in the EU wide perspective, but one of the highest amongst catching-up economies. Households started deleveraging in 2011, but progress was slow due to long loan maturities and a rising debt repayment burden. As real estate prices started to adjust, credit growth to the household sector fell. As almost half of the loans extended were granted for real estate purchases, the average duration of the outstanding household debt remains high. A sharp deterioration in labour market conditions and decreasing disposable income hindered swift debt repayment and increased the household debt burden. As in the corporate sector, the recession also contributed to the slow deleveraging process. Aggregate household debt therefore contracted by only about 3 pps between 2010 and 2015, with 1.4 pps of the change in 2015 alone. Graph 4.2.4:Contributions to change in total households debt Source: Croatian National Bank, European Commission (Eurostat)

The legislated conversion of Swiss franc loans into euros accelerated household deleveraging in 2016. The conversion of Swiss franc-denominated loans into euro-denominated loans, stipulated in September 2015, has significantly reduced household debt as it reduced principal and future instalments of the vast majority of the relevant borrowers. Moreover, data suggest that in some cases households opted for refinancing along with the conversion of their loans, by taking out kuna-denominated loans. Despite a feeble increase in the demand for new loans, due to the conversion of the Swiss franc loans and the appreciation of the kuna, the household debt-to-GDP ratio is set to have fallen by 2.5 pps in 2016. Pressures to reduce household debt are subsiding as labour market conditions improve, real estate prices stabilise and interest rates remain at historically low levels. Lower debt levels and, even more importantly, low interest rates have pushed down households' debt servicing burden (i.e. the interest paid on outstanding debt) to 0.4 % of GDP in 2015, well below the record of 1.8 % of GDP reached in 2009. As the situation on the labour market keeps improving and real estate prices show signs of bottoming out, residual pressure to reduce debt level appears contained (Croatian National Bank, 2014, p. 27-30). According to the Commission's 2016 winter forecast, households’ saving rate is set to decline to just above 11 % over 2017-2018 period. It is therefore unlikely that the debt-to-GDP ratio will see similar sharp reductions. The debt burden is no longer dragging household consumption, but exposure to interest and currency risk remains high. In the current low interest rate environment, macroeconomic risks stemming from high debt levels appear contained. The sinking debt burden is contributing to the recovery in consumption. Nonetheless, household bank loans exposed to currency risk still amounted to around 22 % of GDP in mid-2016, albeit a small share of households is likely hedged through their foreign currency-denominated financial assets or revenue streams. Household borrowers in Croatia who contracted variable interest rate loans are also exposed to interest rate risk, especially in mortgages, due to the loans' long duration. As with corporate debt, risks currently appear limited and have further decreased over the last year. 4.2.3.Financial sector The profitability of the banking sector was affected by the conversion of Swiss franc loans into euros, but the sector has been recovering since then. The conversion legislation allowed Swiss franc borrowers to convert their loans into euros at historical currency and interest rates. This resulted in a gross loss estimated at HRK 7.6 billion (Ministry of Finance, 2016) for the banks — roughly 2.3 % of GDP — which hit their profitability immediately in 2015 and subsequently weakened their capital positions. The conversion insulated Swiss franc borrowers from the effects of the franc's appreciation, but the government took a blanket approach and did not specifically target distressed borrowers. In addition, it may have damaged legal certainty and investor confidence. The measure is currently subject to legal proceedings, which may eventually result in a substantial liability for the state budget. Graph 4.2.5:Key indicators of the Croatian banking sector Source: Croatian National Bank Asset quality has been improving since mid-2015 thanks to the acceleration of sales of impaired assets. The ratio of non-performing loans (according to the national definition ( )) to gross loans declined from 16.6 % at end-2015 to 14.6 % in September 2016, the lowest level in the last 3 years. The ratio of non-performing housing loans in all currencies fell from 9.8 % to 8.5 % over the same period. Similarly, the share of non-performing loans to non-financial corporations dropped from 34.7 % to 30.0 % over the period. Preliminary analysis suggests that sales of non-performing loans have been a principal driver behind these improvements. The increase in sales was probably driven by both supply and demand factors; parent banks have more actively reduced their portfolios of such loans, while buyers have recognised the potential of the Croatian market. The progressive and automatic provisioning requirements introduced by the central bank in 2013 could have been an important driver, as this policy has continuously increased the coverage of the non-performing loans (see Graph 4.2.6). Section 4.5.3 explains why it is difficult to monitor the impact of the revised insolvency regulation on the process of resolving non-performing loans. At this stage, it is also difficult to assess the role played by the conversion of Swiss franc loans into euro loans in helping reduce non-performing loans. Despite recent improvements, the proportion of such loans in Croatia remains high, both historically and in comparison with the EU average. Table 4.2.1:Financial soundness indicators, all banks Source: European Central Bank The recently adopted tax reform may provide further incentives to the banks to write off the non-performing loans and provide a fresh start to borrowers. Until recently, banks have reportedly been discouraged from writing off their non-performing loans because of ambiguities in tax deductibility rules. The recent tax reform (see chapter 4.1) allows banks to treat the provisions related to the non-performing loan as tax-deductible expenses when writing it off. This could shift the resolution strategy from sales towards writing off. However, deductibility would be recognised only during 2017 for non-performing loans and related provisions that were booked as such, according to the Croatian National Bank's definition, in the banks’ balance sheets as of end-2015. There are signs of a recovery in new domestic currency lending and in domestic currency deposits. The share of domestic currency loans in total loans for households has increased substantially, from 28 % at end-2014 to over 40 % by September 2016. This is due to increased demand for kuna loans, either through new lending or through the refinancing of existing foreign currency loans. It may also reflect prudential measures that encourage banks to provide more domestic currency loans ( ). Kuna lending by banks has increased due to the marked increase in kuna deposits by both households and corporates. In contrast, deposits by households in foreign currency have fallen since 2015. Graph 4.2.6:Non-performing loans developments Source: Croatian National Bank A pick-up in deposits, coupled with continuous deleveraging, has improved the financial sector's external position. As deposit growth outpaced credit growth and domestic market experienced ample liquidity, the financial sector started reducing its external debt. Between 2011 and 2015 the external debt-to-GDP ratio dropped by more than 16 pps. Banks intermediated the bulk of this reduction and consequently now have positive net external position ( ). However, gross external debt remains at very high levels, as does the net international investment position. In June 2016 gross external debt and the net international investment position were at 97 % and -75 % of GDP, respectively. Banks remain exposed to currency- and interest rate-induced credit risk. The Croatian economy remains heavily euroised, due to historical mistrust in the domestic currency as a store of value after frequent episodes of hyperinflation in the 1980s and early 90s. The direct exposure of the financial sector to currency risk is — and has always been — limited, with relatively small unhedged positions. The financial sector nevertheless remains exposed to indirect (i.e. currency-induced) credit risk due to the largely unhedged position of households ( ) and non-financial corporations. High exposure to indirect credit risk became clear in the wake of the depreciation of the kuna against the Swiss franc. However, the system is currently exposed to currency-induced credit risk only regarding the euro, against which the domestic currency has a proven track record of stability due to the Croatian National Bank’s firm commitment in managing the float. The future transposition of the Mortgage Credit Directive and its foreign currency loans provisions would provide additional protection of the borrowers in foreign currency, allowing them to convert the loan into domestic currency at the market exchange rates, while also ensuring they are informed of the risks that such loans entail. The independence of the central bank could potentially be undermined by pending amendments to the Central Bank Act. The draft amendments would strengthen public authorities' powers of scrutiny of the Croatian National Bank in a way that may infringe the principle of central bank independence and the ECB's confidentiality rules. The ECB expressed these concerns in two successive opinions, in June and October 2016 (European Central Bank, 2016). Its concerns mainly relate to the remit of the State Audit Office’s audit powers, notably access to confidential information, and Parliament’s right to vote on the National Bank’s reports. The ECB points out that national central banks and members of their decision-making bodies are prohibited from seeking or taking instructions from EU institutions, bodies or agencies, from any government of a Member State and from any other body. Parliament has adopted a conclusion on accepting the draft law without taking on board the ECB’s concerns. The law still has to go through its second reading in Parliament before it is formally adopted. 4.2.4.Access to finance Access to bank loans for small and medium sized enterprises is gradually improving. Banks are the main source of external financing, in particular for small and medium-sized enterprises (SMEs). Although their access to finance is improving, the latest survey on the access to finance of enterprises indicates that this remains more of a problem for Croatian SMEs than for their EU peers. In 2016, 61 % of the SMEs surveyed that applied for a bank loan were granted it, a decline from 77 % the year before. For 26 % the application was rejected, the loan offer was too expensive or they received a smaller loan than they had applied for. This was an increase from 23 % the year before. The remaining 13 % were still awaiting the outcome of their application. The impact of rejected loan applications on SMEs could be further mitigated, and repeated rejections avoided, through activities aimed at mandating financial intermediaries to provide feedback to SMEs on their loan applications (European Commission, 2016b; ECB, forthcoming). Apart from direct bank lending, other major sources of financing are loans and credit lines with subsidised interest rates from the Croatian Bank for Reconstruction and Development (HBOR) implemented through counties and commercial banks. European Structural and Investment Funds are expected to improve SME financing but other potential sources of financing are largely untapped. A set of new financial instruments supported by the European Regional Development Fund and European Social Fund (ESF) to the tune of EUR 310 million are expected to considerably ease access to finance with an expected leverage of over 3.6. The instruments comprise small development loans, guarantees, subsidies for guaranteed loans, and growth and expansion loans. The funding should give a boost to entrepreneurship and SME activity. It should also lead to measures that encourage the creation of businesses and enable the financing of newly established companies (European Commission, 2016b; ECB, forthcoming). In 2016 a seed co-investment fund worth EUR 2.5 million was launched in order to strengthen risk capital financing for innovative SMEs (IBRD, 2015). Ongoing reforms in the capital markets could improve access to finance, but challenges remain. After the acquisition of Ljubljana Stock Exchange by Zagreb Stock Exchange in 2015 and the recent activities undertaken to support the SEE (south-east Europe) Link and the regional Central Counterparty (CCP) service, Croatia has developed the potential to become an important regional capital market player. Other initiatives, such as the development of a domestic covered bond instrument and market, are also progressing. The remaining challenges could be addressed by measures such as increasing the number of initial public offerings by SOEs on the Zagreb Stock Exchange and further initiatives to boost local currency financing ( ). 4.3. Labour market, social policies and education

4.3.1.Labour market The labour market is recovering but continues to face challenges. The unemployment rate soared from less than 9 % in 2008 to 18 % in August 2013 and, according to both national accounts and the Labour Force Survey, the rate of job destruction peaked at the end of 2013. The labour market started to recover in 2014 and in 2016 the unemployment rate declined to 12.8 %, from 16.3 % in 2015. The unemployment rate among people aged 15-24 also fell significantly, from 41 % in Q3-2015 to 28 % a year after. The share of young people who were not in employment, education or training, fell from 19.6 % in 2013 to just over 18.5 % in 2015. Despite these improvements, unemployment remains significantly above the EU average, including for young people, and almost two thirds of the unemployed have been without a job for more than a year. Moreover, a significant drop in the activity rate explains more than half of the overall reduction in the unemployment rate (see Graph 4.3.1). Graph 4.3.1:Change in the unemployment rate: contribution of employment and participation Source: Eurostat, Commission calculations The still high unemployment in combination with persistently low and declining activity points to a large untapped labour potential. In 2016, the activity rate (age 15-64) declined by 2.5 pps., to 65.6 %, with particularly large falls among the low skilled, especially those of prime age (25 to 55 years) (see Graph 4.3.2). Limited availability of attractive job opportunities may have discouraged labour market participation and contributed to increasing migration outflows. Indeed, the share of 'discouraged' workers (jobless people available to work but not seeking employment) amounted to 5 % of the total population (15-74) in 2015, which is more than double compared to the EU average and has increased significantly since 2008 (3 %). Skills deficiencies, care responsibilities as well as multiple pathways to early exits represent further barriers to labour market participation. Going forward, the still high number of the long-term unemployed poses an additional risk to labour market participation rates due to their declining employability over time. Some steps have been taken to improve support to the long term unemployed to make them more employable and help them get back into work. However, there appears to be no policy focus on bringing more people into the labour market. Graph 4.3.2:Change in activity rate by age and skill level (Q3-2015 and Q3-2016) Source: European Commission (Eurostat) The working-age population is shrinking due to both ageing and emigration. Data for 2015 point to an acceleration of the negative demographic trends recorded in Croatia over the past two decades. Those have been driven both by negative natural population growth and migration outflows, which intensified following EU accession in 2013. Official figures are likely to substantially underestimate the real size of emigration, given that many do not notify the national authorities when leaving the country. Better labour market situation and living conditions in host countries are strong pull-factors for migration. The bulk of migrants are aged 25-50 years, which relates to the above mentioned developments in the labour force. Data from recipient countries indicate that Germany has been by far the most popular destination, followed by Austria and Ireland. The authorities have announced greater efforts in tackling the demographic challenge. Graph 4.3.3:Composition of new retirees by type of pensions Source: European Commission based on data from Croatian Pension Insurance Institute from September 2016 (and projections for the remaining months of 2016). Low employment among older workers is still mainly due to the availability of various pathways to early labour market exits. In 2016 the proportion of new retirees exiting the labour market at the statutory retirement age is expected to have increased marginally. However, the share of those retiring earlier than the statutory retirement age increased, if the different pathways to early retirement (early old age, long-career pensions – the so called Article 35 pensions – and disability pensions) are combined. In addition, the Croatian pension system still features numerous special rules that give entitlement to more favourable conditions – like lower retirement age or higher pension accruals – to categories of workers in occupations classified as arduous and hazardous ( ), in specific sectors like security and defence, and for war veterans ( ). If these categories were included in the share of those retiring earlier, this share would be even higher. Commitments to reform the pension system have not been carried out. The design of the pension system and the lack of policy progress raise serious concerns regarding future pension adequacy, as discussed in Section 4.3.3. Measures aimed at discouraging and reducing access to early retirement ( ) and redefining pension provisions for specific categories are on hold. In 2016 the authorities completed a review of the arduous and hazardous professions benefiting from more generous pension provisions. The planned streamlining of the provisions has not yet taken place, however. The same applies to the planned acceleration of the gradual increase in the statutory retirement age (currently due to be completed by 2038) and of plans to make the retirement age equal for men and women. Efforts on reforming the methodology and assessment framework for disability pensions are ongoing. Other measures enabling longer working lives, including tax incentives and increasing the coverage of labour market policy measures have not been implemented yet. Care responsibilities are an additional barrier to women's participation in the labour market. Croatia lags behind the EU target on the provision of formal childcare, though the situation seems to be improving slowly, especially for full-time childcare for children under three. The lack of nation-wide policies has resulted in large disparities across municipalities in available places and costs. As discussed in previous year's country report, care responsibilities particularly affect elder women, who consequently retire prematurely from the labour market: in the broad age bracket 45-59, care responsibilities explain about one third of the inactivity among Croatian women (well above the EU average). In addition, Croatia is one of the few EU countries where paternity leave is unpaid. Regarding care for dependant relatives, in most cases the rights of carers are not recognised in Croatia ( ). Work contracts allow little flexibility in terms of reduced hours, leave arrangements and sharing of rights to enable carers, mostly women, to balance work and care responsibilities. Job creation has mostly relied on temporary contracts. Following the 2013 and 2014 labour market reforms, which increased the flexibility of the labour market, there has been a surge in temporary contracts. This is especially the case among young people: for those aged 15-29, 47.1 % of contracts in 2015 were temporary, compared with an EU average of 32.2 % for the same age group. The share of fixed-term contracts in total employment grew from 15.6 % in Q3-2013 to 24.2 % in Q3-2016. The trend is visible in all sectors of the economy but especially in construction, private services and tourism, due to the high seasonality of their activity. The 2016 country report showed that these trends have been underpinned by both increased inflows of people moving into employment and a higher probability of temporary employment for all categories of workers (see graph 4.3.4) ( ) . In addition, some atypical contracts that are designed only for specific circumstances – professional contracts ("ugovor o djelu") and student contracts – appear to be increasingly used (CELSI, 2016). On a positive note, recent data show that an increasing share of temporary employees (37.8 % in 2015) did make the transition to permanent employment. Labour costs are projected to increase marginally. Despite subdued productivity developments, nominal unit labour costs fell by almost 5 % in 2013-2016 in response to the labour market slack. The steep decline in the number of jobseekers, despite low and declining participation, is expected to stimulate renewed wage pressure. In 2016, wages are expected to have increased by around 1.8 %. Due to negative inflation, this implies a 2.4 % growth rate in real terms. Wages are projected to increase above productivity in 2017 and 2018, causing a small increase in unit labour costs. Graph 4.3.4:Temporary employment by labour market status 1 year before, and share of temporary contracts in total employment Source: Eurostat There have been no reforms of the wage setting framework. The adoption of new legislation on public sector wages, aiming to better harmonize wages across the public administration and public services ( ), has been postponed by more than 2 years, to 2019. A common methodology and guidance for negotiating, coordinating and monitoring collective agreements in the public administration has been developed and adopted by the government in February 2017. The two basic collective agreements regulating the rights of civil servants and public servants expired in 2016. They will both be temporarily extended and re-negotiated in 2017, partly with a view to increasing synchronisation of bargaining cycles ( ). The government negotiated a 6 % wage increase for civil servants under a 2009 agreement with the trade unions (see chapter 4.1). It is still due to negotiate the wage increase for the public servants. This may add to wage pressure in the private sector through demonstration effects. As for SOEs, no further steps have been taken to set up a coordinated system for collective bargaining. Changes to the minimum wage are under consideration. The minimum wage currently in force in Croatia is on the lower end of the EU rank ( ). In 2016, the authorities commissioned a study on the institutional design and impact of the minimum wage in Croatia (Institute of Economics Zagreb, 2015). The study highlights significant variations in the coverage and level of the minimum wage (relative to gross earnings) across regions and sectors within Croatia. Employees earning the minimum wage are predominantly women, people with relatively lower education, working in services and in rural areas. Young people are also concerned. The study recommends reviewing the definition of the minimum wage, in consultation with the social partners, and making the annual revision process more predictable and transparent. It also recommends the establishment of an independent expert body to inform the discussions of social partners and the authorities. In 2017, the government announced an increase in the minimum wage of 5 % but it is not clear to what extent the recommendations from the study will be taken on board. The personal income tax reductions implemented recently decrease the progressivity of the tax system. The reform of the personal income tax that entered into force in January 2017 (see Section 4.1) ( ) comes on top of a previous PIT reform, in force since 2015. The latter had already increased the tax allowance and broadened the intermediary tax bracket (the upper limit was raised from HRK 8 000 to 13 000). The tax cuts are expected to mainly benefit higher incomes, without increasing work incentives for low skilled workers. See Box 4.3.1. 4.3.2.Education and skills

The low and deteriorating basic skills of many pupils will eventually lead to skills gaps in the labour market. In the 2015 OECD Programme for International Student Assessment (PISA) of 15 year-olds, Croatia recorded one of the worst results in the EU in applied science and mathematics. Compared to 2012, the proportion of low achievers increased in mathematics (from 30 % to 32 %) and most significantly in science (from 17 % to 25 %), undoing the progress made up to 2012 (OECD, 2016). The proportion of top performing students is on average below 5 %, demonstrating a lack of focus on identifying and supporting talented students. However, the Trends in International Mathematics and Science Study (2015) shows that younger pupils (10 year olds) are significantly better at solving theoretical exercises in mathematics and science than in 2011, and that the best and poorest performers are fairly evenly distributed (IEA, 2015). As far as digital skills are concerned Croatia remains below the EU average, but there has been improvement compared to last year with 27.9 % of individuals having no digital skills, 17.4 % low skills, 21.3 % basic skills and 33.3 % above basic skills (European Commission, 2017a). The national ʻe-Schools’ project aims at ensuring that digitally competent teachers have access to adequate ICT equipment and that they develop and use e-content in classrooms. The reform of the education system is being reassessed and its implementation is significantly delayed. Over the past 2 years policy developments in the education system have been dominated by the implementation of the strategy for education, science and technology. A part of the strategy is a comprehensive and ambitious curricular reform. Since the beginning of 2015, school curricula have been revised and refocused on improving content and better incorporating transferable skills ( ). While teacher unions, parents and the non-governmental sector expressed support for the reform, strong criticism was voiced by some parts of academia. As a result, the coordination body in charge of the reform resigned and the pilot implementation was delayed, though a public consultation on the final draft of curricular documents went ahead between June and November 2016. The lack of consensus on some key aspects of the reform and the ways forward ultimately led to a loss of momentum, although there appears to be political will to restart the process in 2017. The labour market recovery has revealed shortages in the supply of labour at both ends of the skill spectrum. Despite Croatia's still high unemployment and level of inactivity, employers in transportation, construction, shipbuilding, tourism and other seasonal sectors continue to report shortages of low and medium skilled workers and call for increased import quotas for foreign workers. The limited attractiveness of seasonal jobs certainly explains part of this, while for other sectors shortages are partially linked to outmigration. A recent study (CEDEFOP, 2016) shows there are also shorta