COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Croatia 2014
Date: 2014-03-05
Institutions: European Commission
Subjects: Croatia, Euro Group (euro area), competitiveness, economic growth, financial services, indebtedness, macroeconomics, public debt, stability pact

EUROPEAN 
COMMISSION 

Brussels, 5.3.2014  
SWD(2014) 82 final 

COMMISSION STAFF WORKING DOCUMENT 

Macroeconomic Imbalances - Croatia 2014 

EN 

   EN 

 
 
 
 
  
 
Results  of  in-depth  reviews  under  Regulation  (EU)  No  1176/2011  on  the  prevention  and  correction  of 
macroeconomic imbalances 

Croatia  is  experiencing  excessive  macroeconomic  imbalances,  which  require  specific  monitoring  and  strong 
policy action. In particular, policy action is required in view of the vulnerabilities arising from sizeable external 
liabilities, declining export performance, highly leveraged firms and fast-increasing general government debt, all 
within  a  context  of  low  growth  and  poor  adjustment  capacity.  The  Commission  will  put  in  motion  a  specific 
monitoring of policy implementation, and will regularly report to the Council. 

More specifically, after an expansionary phase, in which imbalances accumulated, Croatia is now experiencing a 
prolonged  bust,  in  which  a  range  of  external  and  internal  risks  have  come  to  the  fore.  External  rebalancing  is 
beset by important risks pending the reduction of Croatia's foreign liabilities to safer levels and is conditioned on 
improved competitiveness and broadening exports beyond tourism to support growth. The deleveraging of non-
financial  corporates  is  still  at  an  early  stage  and  non-performing  loan  developments  in  this  segment  need 
monitoring. State-owned enterprises, which in some sectors still play a dominant role and which are often un-
restructured, are overall highly indebted and weakly profitable. Croatia has the lowest activity and employment 
rates  in  the  EU,  which  is  partly  related  to  underlying  institutions  and  policy  settings.  Better  labour  market 
functioning  will  be  crucial  to  support  the  growth  and  adjustment  needed  in  view  of  external  and  internal 
vulnerabilities.  On  nearly  a  range  of  standard  indicators,  Croatia's  business  environment  ranks  significantly 
below  the  average  for  central  and  eastern  European  Member  States.  These  factors  combine  to  lower  potential 
growth, which hinders private sector balance sheet repair and increases the required fiscal consolidation effort. 
There is a need for significant additional fiscal consolidation efforts to curtail the deficit and prevent debt from 
rising unsustainably. Croatia is in EDP and needs to take effective action to address the excessive deficit by 30 
April 2014. On current trends, in the absence of additional measures, Croatia risks missing its targets by a large 
margin in 2014. 

Excerpt of country-specific findings on Croatia, COM(2014) 150 final, 5.3.2014 

2 

 
 
 
Executive Summary and Conclusions 

1. 

Introduction 

2.  Macroeconomic Developments 

3. 

Imbalances and Risks 

3.1.  EXTERNAL SECTOR ANALYSIS AND COMPETITIVENESS ISSUES 

3.1.1.  External sector trends 
3.1.2.  External Competitiveness 

3.2. 

INDEBTEDNESS AND DELEVERAGING DYNAMICS 
3.2.1.  Private sector indebtedness 
3.2.2.  Public indebtedness 

3.3.  MONETARY AND FINANCIAL SECTOR ISSUES 

3.3.1.  Macro-prudential policy in Croatia in the run-up to the crisis 
3.3.2.  Monetary and exchange rate issues 
3.3.3.  The situation of the banking sector 

4. 

Policy Challenges 

References 

LIST OF TABLES 

2.1.  Key economic, financial and social indicators - Croatia 
3.1. 
Structure of the Croatian banking system 
3.2.  Capital and loan loss provisions analysis 

LIST OF GRAPHS 

Selected labour market indicators 

2.1.  GDP dynamics and contributions 
2.2.  CPI inflation 
2.3. 
2.4.  5-year CDS USD 
2.5.  Current account and components 
2.6.  Gross external debt 
3.1.  Current account composition 
3.2.  Exports and Imports 

7 

11 

13 

19 

19 
19 
22 
34 
35 
41 
48 
49 
50 
52 

61 

63 

18 
53 
57 

13 
14 
14 
16 
16 
17 
19 
19 

3 

 
 
 
 
3.3.  Current account financing 
3.4.  Net IIP 
3.5.  Current account adjustment in selected Member States 
3.6.  Decomposition of rate of change of NIIP 
3.7.  Gross IIP - liability-side breakdown % of total 
3.8.  Gross external debt per sector 
3.9.  Export market share decomposition 
3.10.  Volume of exports of goods and services 
3.11.  Trade openness 
3.12.  Value of exports of travel services 
3.13.  Compensation and productivity 
3.14.  Nominal ULC 
3.15.  Adjusted wage share 
3.16.  ULC-deflated REER 
3.17.  REER deflated for nominal wage costs in manufacturing 
3.18.  Doing business 2014, country ranking 
3.19.  Economic freedom 2014 index, country ranking 
3.20.  Global competitiveness 2013-14 index, country ranking 
3.21.  FDI inflows 
3.22.  FDI inflows per sectors, % of total 
3.23.  Sectoral structure of inward FDI stock 
3.24.  Debt by sector, non-consolidated 
3.25.  Private sector debt 
3.26.  Decomposition changes in debt-to-GDP ratio, households 
3.27.  Decomposition changes in debt-to-GDP ratio, NFC 
3.28.  NFC leverage indicators 
3.29.  Household leverage - Croatia and CEE10 
3.30.  NFC leverage - Croatia and CEE10 
3.31.  Credit institutions' claims 
3.32.  Consolidated central government 
3.33.  General government balance 
3.34.  Structural government balance 
3.35.  General government debt 
3.36.  Contingent state liabilities 
3.37.  T-bills auctions, average yields 
3.38.  Kuna exchange rate 
3.39.  Croatia - Real and nominal effective exchange rates (42 countries; monthly data) 
3.40.  NPLs and coverage ratio, Q3 2013 
3.41.  Key financial indicators 
3.42.  Corporate debt evolution 
3.43.  Banking and leasing assets 
3.44.  Loans and deposits 

20 
20 
20 
21 
21 
21 
22 
22 
23 
23 
26 
26 
27 
27 
27 
30 
31 
31 
32 
32 
33 
34 
35 
36 
36 
36 
40 
40 
41 
44 
44 
44 
44 
45 
46 
51 
51 
53 
53 
54 
54 
55 

4 

 
 
3.45.  Property price index 

LIST OF BOXES 

Financial Performance of Firms, including SOEs 

3.1.  Croatia’s declining goods exports 
3.2.  Employment protection legislation as impediment to competitiveness 
3.3. 
3.4.  Pre-bankruptcy settlement legislation 
3.5.  Public debt sustainability analysis 
3.6.  Banks’ exposure to the general government and SOEs 

60 

25 
30 
38 
43 
47 
58 

5 

 
 
 
 
 
 
 
EXECUTIVE SUMMARY AND CONCLUSIONS 

EXECUTIVE SUMMARY 

In the Alert Mechanism Report (AMR) published on 13 November 2013, the Commission found it useful 
to investigate the nature of and potential risks related to Croatia's external position, trade performance and 
competitiveness, as well as internal developments. To this end this In-Depth Review (IDR) provides an 
economic analysis of the country's macroeconomic and structural situation in line with the scope of the 
surveillance  under  the  Macroeconomic  Imbalance  Procedure  (MIP),  with  a  view  to  understanding 
whether  imbalances  exist.  Croatia  joined  the  EU  on  1  July  2013  and  this  is  its  first  IDR.  The  main 
observations and findings of this analysis are: 

•  After  an  expansionary  phase  up  to  2009,  in  which  imbalances  accumulated,  Croatia  is  now 
experiencing  a  deep  and  prolonged  downturn,  in  which  a  range  of  external  and  internal  risks 
have come to the fore. Delayed restructuring of the manufacturing sector and an inability to establish 
sizeable, competitive export industries beyond tourism limited Croatia's participation in regional trade 
integration  during  the  boom  years  as  a  result  of  which  it  has  remained  one  of  the  least  open  of  the 
smaller  EU  member  states  with  low  relative  income  levels.  A  widening  current  account  deficit  was 
largely funded by the foreign parents of Croatian banks and by Foreign Direct Investment (FDI) into 
inward-oriented  sectors  of  the  Croatian  economy.  As  the  global  financial  crisis  unfolded,  capital 
inflows  suddenly  stopped  in  2009.  The  impact  on  Croatia  was  severe:  domestic  demand  rapidly 
contracted and the ensuing recession led to soaring unemployment. The country entered a long-drawn 
recession  from  which  it  has  not  yet  recovered.  Despite  the  reversal  in  the  current  account, 
vulnerabilities such as high external liabilities, uncompetitive exports, a corporate debt overhang and 
growing  public  sector  indebtedness  persist.  Structural  weaknesses  have  contributed  to  these 
imbalances, including a poor business environment and a malfunctioning labour market. State-owned 
enterprises  still  play  a  dominant  role  and  are  often  highly  indebted  and  weakly  profitable.  These 
factors also combine to lower potential growth, which hinders private sector balance sheet repair and 
increases the required fiscal consolidation effort.    

•  External rebalancing is beset by important risks pending the reduction of Croatia's high foreign 
liabilities. Domestic economic weakness reduces the affordability of foreign liabilities and limits the 
appeal  of  Croatia  to  lenders  and  existing  investors  in  inward-oriented  industries.  The  recession 
therefore increases Croatia's vulnerability to capital flow reversals. For 2014 public and private sector 
external re-financing needs are in excess of 20% of GDP. The high share of FDI in overall liabilities 
does reduce volatility to an extent, although it comprises a substantial portion of intra-company loans. 
Dramatically  lowered  import  volumes  have  closed  the  current  account,  but  the  small  surpluses 
forecast for 2014 and 2015 will not suffice to bring the negative net international investment position 
to a safer level.  

•  Croatia's  low  competitiveness  had  been  eroding  export  market  shares  even  before  the  crisis. 
Croatia  has  been  and  remains  a  comparatively  expensive  production  location.  After  2004,  Croatia's 
export market shares started falling from their already low level. These losses have accelerated since 
the crisis, indicating the persistence of a substantial competitiveness gap. Export market share losses 
have been concentrated in goods exports, where labour cost levels stand out in regional comparison, 
whereas overall labour costs have grown moderately since 2009 in comparison with competitors. High 
costs combine with a wide range of non-cost-competitiveness deficiencies. One-off factors, including 
the  restructuring  of  the  shipbuilding  and  chemicals  industries,  have  interacted  with  low  overall 
competitiveness to generate a decline in goods exports in 2013. 

•  Weaknesses  in  the  labour  market  and  in  the  wider  business  environment  have  amplified  the 
impact  of  the  crisis  and  prevent  adjustment  towards  stronger,  more  sustainable  growth  and 
employment. The employment rate in Croatia was consistently low throughout the past decade and, 
from 2010, has been the lowest out of the (now) EU28 countries. The protracted recession has pushed 

7 

 
the  unemployment  rate  above  17%  in  2013,  a  twofold  increase  since  2008,  with  young  people  and 
low-skilled workers particularly affected. Beyond cyclical developments, these dismal labour market 
outcomes  are  also  partly  related  to  aspects  of  underlying  institutions  and  policy  settings.  The  social 
protection system provides multiple avenues for early withdrawal from and discourages participation 
in  the  labour  market.  Obstacles  in  the  business  environment  include  a  high  regulatory  burden, 
inefficiencies  in  the  administration  of  construction  permits  and  property  registration,  prolonged 
litigation and bankruptcy procedures, weak protection of investments, and high policy uncertainty.  

•  The non-financial private sector, and in particular non-financial corporations, entered the crisis 
highly  leveraged  as  a  result  of  rapid  credit  growth  in  the  preceding  years.  Countercyclical 
monetary  policy  loosening  and buffers  in  the  financial  system  initially  absorbed  some  of  the  shock. 
This  deferred  the  onset  of  contractionary  credit  retrenchment  and  balance  sheet  repair  in  the  non-
financial  corporate  sector.  But  the  high  level  of  euroisation  has  limited  the  central  bank's  room  for 
manoeuvre. Deleveraging pressures began to  grow  as of 2011 but refinancing by  banks  and  foreign 
parent  companies  has  on  the  whole  remained  available  and  the  reduction  in  corporate  sector 
indebtedness is proceeding at a rather slow pace. Many state-owned enterprises, in particular, appear 
to  have  comparatively  high  debt  levels,  especially  in  view  of  their  overall  weak  profitability. 
Household balance sheets are also under pressure, notably as a result of labour market developments, 
but the sector's lower level of indebtedness limits vulnerabilities.  

•  The  largely  foreign-owned  banking  system  has  shown  resilience.  Previous  macro-prudential 
measures helped to ensure that banks built significant capital and liquidity buffers, and both of these 
proved useful during the crisis. Still, the weak economy has started to interact with the banking sector, 
and  non-performing  loans  (NPLs)  to  corporate  borrowers  have  risen  to  high  levels.  Despite  some 
recent  signs  of  stabilisation,  these  developments  will  need  to  be  closely  monitored.  The  persistent 
weakness  in  the  economy  has  also  led  to  a  reduced  demand  for  credit  from  the  private  sector,  and 
banks have compensated by increasing lending to public entities. A continuation of these trends would 
be problematic, however, in light of the high level of indebtedness of several SOEs. 

•  Loose fiscal policies in the downturn have exerted sustained pressure on the general government 
deficit and debt. The general government deficit averaged 6% of GDP in 2009-2013. Deficit trends 
and  sizeable negative  stock-flow  adjustments  have  caused  a  sharp  deterioration of  Croatia’s  general 
government debt ratio, which had been comparable to those of regional peers before the crisis but has 
risen  sharply  to  reach  64.9%  of  GDP  at  the  end  of  2013.  Commission  projections  and  sensitivity 
analysis  indicate  the  need  for  significant  additional  consolidation  efforts  to  curtail  the  deficit  and 
prevent  debt  from  rising  unsustainably.  The  high  foreign  currency  share  and  the  relatively  short 
average maturity of the debt, together with contingent fiscal liabilities arising in troubled state-owned 
enterprises, add to sovereign financing vulnerabilities.   

The  IDR  also  discusses  the  policy  challenges  stemming  from  these  imbalances  and  what  could  be 
possible avenues for the way forward. A number of elements could be considered:  

•  Greater  sustainability of  Croatia's  external  position  is  conditioned on  improved cost and  non-
cost  competitiveness  and  broadening  exports  beyond  tourism.  This  would  be  instrumental  to 
attract  substantial,  high quality  FDI  and  regenerate Croatia's  industrial  fabric  to  support  rebalancing 
and  lay  the  foundations  for  sustainable  growth  and  the  creation  of  jobs.  These  objectives  can  be 
further supported by efficient leverage of European Structural and Cohesion funds. In view of the high 
external liabilities, and the extent of foreign-currency denominated obligations of the financial, non-
financial and public sectors, the maintenance of strong, stability-oriented macroeconomic policies is a 
strategic imperative.  

8 

 
 
•  The low activity and employment rates and the scale of the labour market adjustment arising 
from  the  decline  of  Croatia's  manufacturing  industries  represent  a  major  policy  challenge.  A 
comprehensive  response  could  involve  carefully  reconsidering,  and,  where  necessary,  adjusting  a 
number of institutions and policies affecting labour market functioning. Building on reforms recently 
undertaken,  there  could  be  further  scope  to  reduce  inactivity  traps,  to  make  employment  protection 
less  onerous  for  businesses  and  to  enhance  the  effectiveness  and  reach  of  Active  Labour  Market 
Policies.  In  view  of  the  multiple  and  wide-ranging  business  environment  challenges  that  hinder 
adjustment  and  constitute  a  barrier  to  investment  and  exports,  there  is  scope  for  concerted 
improvements.   

•  In  view  of  private  sector  over-indebtedness,  it  would  be  important  to  ensure  the  necessary 
conditions  for  a  smooth  continuation  of  the  deleveraging  process,  including  through  proper 
functioning  of  insolvency  and  debt-restructuring  regimes.  Correctly  functioning  financial 
intermediation  is  also  important,  notably  to  ensure  that  credit  is  correctly  allocated  within  the 
economy as deleveraging continues. It may be useful to monitor the increase in bank lending to SOEs.  

•  Close  monitoring  and  supervision  of  systemic  banks  will  continue  to  be  important,  in 
cooperation  with  home  country  supervisors.  In  this  respect,  the  ongoing  ECB  comprehensive 
assessment  exercise  will  include  the  four  largest  Croatian  banks,  through  their  respective  parents. 
There  is  scope  to  consider  complementing  this  with  additional  supervisory  diagnostic  steps  from  a 
Croatian perspective. 

•  There is a pressing need for high-quality, structural fiscal consolidation measures. Compliance 
with  the  targets  contained  in  the  excessive  deficit  procedure  opened  on  28  January,  2014  and 
thereafter  with  the  requirements  of  the  SGP    would  ensure  that  Croatia's  debt  is  on  the  sustainable 
path.  A  number  of  supporting  polices  can  be  considered,  including  tax  shifting  towards  less  mobile 
factors, substantial reductions in subsidies to firms, and improved targeting of and administration of 
social  benefits.  Credible  fiscal  policy    supported  by  fiscal  institutions  and  rules,  at  all  levels  of 
government, will support sustained deficit and debt reductions.  

9 

 
 
1. 

INTRODUCTION 

On 13 November 2013, the European Commission presented its third Alert Mechanism Report (AMR), 
prepared  in  accordance  with  Article  3  of  Regulation  (EU)  No.  1176/2011  on  the  prevention  and 
correction  of  macroeconomic  imbalances.  The  AMR  serves  as  an  initial  screening  device  helping  to 
identify  Member  States  that warrant further  in-depth  analysis  to  determine  whether  imbalances  exist or 
risk  emerging.  According  to  Article  5  of  Regulation  No.  1176/2011,  these  country-specific  “in-depth 
reviews”  (IDR)  should  examine  the  nature,  origin  and  severity  of  macroeconomic  developments  in  the 
Member State concerned, which constitute, or could lead to, imbalances. On the basis of this analysis, the 
Commission will establish whether it considers that an imbalance exists in the sense of the legislation and 
what type of follow-up in terms it will recommend to the Council. 

The  AMR  suggested  the  need  to  look  more  closely  at  whether  Croatia  is  exhibiting  macroeconomic 
imbalances of an external and internal nature, in the context of a contracting economy. On the external 
side,  the  AMR  highlighted  the  high  negative  net  international  investment  position  and  poor  export 
performance,  reflecting  unfavourable  product  specialisation  and  geographic  orientation.  On  the  internal 
side,  the  AMR  highlighted  high  private  sector  debt,  increasing  non-performing  loans,  deleveraging 
pressures, rising public debt and contingent fiscal liabilities, and weaknesses in the business environment, 
domestic  competition  and  labour  market.  To  this  end  this  IDR  provides  an  analysis  of  the  Croatian 
economy in line with the scope of the surveillance under the Macroeconomic Imbalance Procedure (MIP). 

Against this background, Section 2 first provides an overview the general macroeconomic developments, 
Section  3  looks  more  in  detail  into  the  main  imbalances  and  risks.  Section  4  discusses  policy 
considerations. 

11 

 
 
2.  MACROECONOMIC DEVELOPMENTS 

Real economy and price developments 

structural 

Croatia has been mired in recession since 2009. 
Five  years  of  contraction  have  reduced  Croatia's 
real  GDP  by  nearly  12%  and  only  a  muted 
recovery is forecast for the coming two years. The 
2008 global financial crisis brought to the surface 
including 
deep-rooted 
uncompetitive  export 
industries,  a  significant 
private  debt  overhang,  a  weak  labour  market  and 
poor governance of public finances. These factors, 
which are accentuated by the unsupportive external 
environment,  make  economic  adjustment  slower 
and  more  costly  and  have  thereby  lengthened  and 
deepened the recession. The obstacles to stronger, 
more sustainable growth are still firmly in place. 

problems, 

external 

Recent  GDP  developments  underline 
the 
weakness of the economy. Real GDP declined by 
0.9%  year-on-year  in  the  first  three  quarters  of 
2013  following  a  2%  contraction  a  year  earlier. 
Falling  exports  turned  the  contribution  of  net 
to  growth  negative  amid  continued 
exports 
subdued 
on-going 
restructuring  of  the  once  important  shipbuilding 
sector and trade diversion following the exit from 
the  Central  European  Free  Trade  Agreement 
(CEFTA)  area.  Domestic  demand  continued  to 
contract in 2013, but there were signs of a subdued 
rebound,  possibly  supported  by  positive  impacts 
on household consumption and investment activity 
from EU entry.  

demand, 

the 

in  real  GDP  since  2008 

The  decline 
is 
attributable  to  a  sharp  contraction  in  domestic 
demand, chiefly investment (Graph 2.1). From a 
peak  of  28%  of  GDP  in  2008,  investments  have 
plummeted  to  19%,  a  real  decline  entailing  a 
particularly  steep  contraction  of  construction 
activity.  Household  consumption  was  hit  by  the 
rapidly deteriorating labour market, in combination 
with  declining  disposable 
income,  worsening 
consumer  sentiment  and  tighter  bank  lending 
conditions. Net trade made a positive contribution 
to  GDP  for  most  of  the  period  as  depressed 
household and corporate demand caused imports to 
contract  more  than  exports.  Low  and  declining 
labour  utilisation  (the  lowest  activity  rate  in  the 
EU)  and  major  disinvestment  have  dragged 
potential growth into negative territory. 

Graph 2.1: GDP dynamics and contributions

s
p
p
,

%

12

8

4

0

-4

-8

-12

00 01 02 03 04 05 06 07 08 09 10 11 12 13*14**15**
Inventories investment
Consumption
Real GDP growth

Investment (GFCF)
Net exports

Source: Commission services; AMECO; * - estimate; ** - forecast

the  ability  of 

Medium-term  prospects  are  slightly  more 
favourable.  A  gradually 
improving  external 
environment  and  access  to  significant  European 
Structural  and  Cohesion  Funds  have  the  potential 
to lift economic activity.(1) The magnitude of this 
impulse  will  depend  on 
the 
authorities to effectively address some of the long-
to  growth. 
standing 
According 
the  Commission  Winter  2014 
forecast  (WF2014),  real  GDP  growth  of  0.5%  in 
2014 is set to be followed by a slight acceleration 
to  1.2%  in  2015.  The  main  risk  to  the  country’s 
short-term growth profile stems from the need for 
significant fiscal adjustment to avoid unsustainable 
debt trajectories and restore credibility.  

structural  bottlenecks 
to 

CPI  inflation  moderated  significantly  in  the 
course  of  2013.  This  reflected  weak  demand  that 
more  than  offset  increases  of  indirect  taxes  and 
regulated  prices.  The  average  annual  inflation 
slowed  down  to  2.2%  in  2013  from  3.4%  a  year 
earlier,  and  is  set  to  further  decline  in  2014, 
according  to  the  WF2014  (Graph  2.2)  in  the 
absence  of  demand-side  pressures  despite  new 
indirect tax increases. (2) Core inflation has  

(1)  Economic  modelling  suggests  structural  and  cohesion 
funds can yield sizeable, permanent GDP increases in new 
member states, although the impact hinges on the quality of 
implementation.  Based  on  the  2007-2013  programme, 
Varga  and  In  ’t  Veld  (2009)  estimate  the  impact  to  be  in 
excess of 3 pp of GDP 

(2)  As of 2014, the increase of the intermediate VAT tax rate 
and  of  the  excises  on  fuel  and  cigarettes  are  expected  to 
add  0.3  pp  to  the  annual  CPI  figure,  according  to  the 
estimates  of  the  central  bank  (assuming  a  70%  pass-
through effect from the VAT increase) 

13 

 
 
 
                                                           
 
2. Macroeconomic Developments 

Graph 2.3: Selected labour market indicators

50

40

30

%

20

10

0

02 03 04 05 06 07 08 09 10 11 12

Activity rate (rhs)
Unemployment rate
Youth unemployment rate
NEET rate
Long-term unemployment rate

Source: Eurostat

%

66

64

62

60

58

56

54

52

50

lasting 

impacts  on 

The  economic  crisis  has  particularly  affected 
young  people  and  low-skilled  workers.  Youth 
unemployment (in the age group 19-24) has soared 
to around 50% in 2013, taking it to a scale that can 
have  potentially 
social 
cohesion.  Structural  features  of  the  labour  market 
lead  to  high  fragmentation  and  significant  hiring 
constraints,  which  disproportionately  affect  new 
entrants to the labour market. The increased use of 
fixed  term  contracts  risks  exacerbating  labour 
market  segmentation,  particularly 
for  young 
people.  The  unemployment  rate  among  the  low-
skilled is also high, while the activity ratio in this 
segment  remains  low  and  on  a  declining  trend, 
which is suggestive of skills mismatches. Budgets 
for  youth  employment  promotion  have  been 
increased  and  some  relevant  measures  have  been 
implemented. 

Rising unemployment is mirrored in worsening 
social  indicators.  The  share  of  people  at  risk  of 
poverty increased by 4 pp in four years, peaking at 
21.3% in 2011. This is in contrast with the relative 
stability  of  this  indicator  in  the  EU,  including 
Member  States  in  Central  and  Eastern  Europe, 
over  the  same  period.  Apart  from  the  stronger 
worsening of the labour market situation in Croatia 
compared  to  the  EU  average,  this  divergence 
appears  to  be  also  the  result  of  insufficient  fiscal 
room for social policies to cushion the effect of the 
crisis. The social implications of job losses are also 
reflected  in  the  high,  and  rising,  share  of  people 
living  in  families  with  low  work  intensity  (16.1% 
in 2012 versus 10.3% in the EU). Structural labour 

 stabilised  at  around 2%  in  the  last  few  years, but 
has  also  started  easing  from  the  second  half  of 
2013. 

Graph 2.2: CPI inflation

%

6

5

4

3

2

1

0

-1

-2

01 02 03 04 05 06 07 08 09 10 11 12 13

EU 28 HICP*

core

headline

Source: HNB; Eurostat; * - provisional for 2013

Labour market developments 

Cyclical 

developments 

Protracted recession has hit the labour market, 
pushing  the  unemployment  rate  above  17%  in 
2013, a twofold increase since 2008 (Graph 2.3). 
Hiring  in  the  already  large  public  sector  and  the 
slow  process  of  restructuring  of  troubled  state-
owned  companies  averted  an  even  steeper  rise  in 
joblessness. 
have 
compounded  long-existing  structural  deficiencies 
that are reflected in one of the lowest employment 
rates in the now EU 28 throughout the past decade. 
These  structural  elements  include  legislation  that 
dampens  job  creation  by  raising  implicit  labour 
costs.  The  social  protection  system  may  also  lead 
to  inactivity  traps  and  discourage  labour  market 
participation. At the same time, the high levels and 
long spells of long-term unemployment reduce the 
employability of the labour force even in times of 
rising  activity,  signalling  skills  gaps,  hiring 
barriers  or  a  combination  of  both.  These 
impediments,  if  not  addressed,  risk  impairing  the 
transmission  of  future  economic  growth  into  job 
creation,  keeping  jobless  rates  elevated  for  longer 
and so accentuating labour market hysteresis. 

14 

 
 
                                                                                   
 
 
2. Macroeconomic Developments 

market  challenges  and  the  low  participation  rate 
thus affect both economic and social outcomes.  

Public finances 

The  pro-cyclical  fiscal  policies  of  the  boom 
years  have  been  followed  by  relatively  loose 
policies  in  the  downturn,  exerting  sustained 
pressure  on  the  general  government  deficit. 
Reform  efforts  to  address  structural  weaknesses, 
mainly  on  the  expenditure  side,  have  remained 
timid.  The  debt  level  was  increased  by  a  further 
4%  of  GDP  in  2009-2011  by  the  assumption  of 
obligations  of  state-owned  companies,  mostly 
related 
to  activation  of  government  credit 
guarantees  that  impact  public  finances  negatively 
via  the  interest  expenditure  channel.  These  trends 
have contributed to more than double the nominal 
debt  since  the  end  of  2008,  reaching  64.9%  of 
GDP at the end of 2013. 

stability  of  Croatia's  public  debt.  According  to 
the Commission's latest forecast, on current trends, 
in  the  absence  of  additional  measures,  Croatia 
would  not be able  to  curb  the  upward  public  debt 
dynamics  (see  Box  3.5  in  Section  3.2.)  on  debt 
sustainability  analysis).  High  domestic  bank 
liquidity,  supported  by  the  central  bank's  policies, 
is  currently  central  to  the  uninterrupted  financing 
of  the  rising  needs  of  the  state  although  the 
authorities  have  continued  to  tap  international 
financial markets. Croatia placed two bonds on the 
US market in 2013, albeit at high, and rising, costs 
(Graph 2.4). (6) Apart from the steep growth in the 
public  debt,  contingent  liabilities  stemming  from 
state guarantees for loans to public companies are 
also  a  cause  of  concern  in  view  of  their  still 
elevated levels and the track record of activation in 
recent years. 

Graph 2.4: 5-year CDS USD

points 

macroeconomic 

After  some  consolidation  measures  in  2012, 
fiscal  policy  was  loosened  again  in  2013.  The 
government  twice  revised  its  cash-based  deficit 
target in 2013, the second time in November by 2 
of  GDP.  Manifestly 
percentage 
overoptimistic 
projections 
underlying  the  budget  combined  with  unexpected 
revenue  shortages  (in  VAT  collection (3)  and 
corporate  income  tax  collection) (4)  as  well  as 
settlements  of  debt  arrears  in  the  healthcare 
sector (5)  drove  a  substantial  wedge  between 
budget  and  outturns.  The  2014  budget  adopted  in 
December  2013  does  not  reverse  the  public-
finance trajectory. A revision is pending in the first 
quarter of the year to take into account the required 
fiscal adjustment in line with the recommendations 
issued  by  the  Council  in  the  context  of  the 
excessive deficit procedure on 28 January 2014. 

Significant  fiscal  consolidation  measures  are 
required  to  safeguard  the  sustainability  and 

(3)  The  change  in  the  methodology  for  VAT  collection  after 
the EU accession (at the point of sale, rather than on import 
has  resulted  in  a  one-off  revenue  loss  estimated  at  HRK 
1.6bn (0.5% of GDP) 

(4)  Corporate income tax revenues declined by HRK 1.4bn (or 
0.4% of GDP) year-on-year in January-November, as some 
companies tried to benefit from the tax break introduced by 
the government. 

(5)  This expenditure increases the deficit on a cash basis by 1 
percentage  point  of  GDP,  but  on  an  accrual  basis  it  is 
expected  to  be  deficit  neutral  as  these  arrears  have  been 
already  recorded  in  deficit  of  previous  years  under  the 
ESA95 methodology. 

700

600

500

400

300

200

100

0

03/01/11

03/01/12

03/01/13

03/01/14

BG

HU

RO

SI

HR

Source: Bloomberg

External sector 

The crisis has induced an abrupt swing from a 
current account deficit of close to 9% of GDP in 
2008 to a surplus of around 1% of GDP in 2013 
(Graph 2.5). Depressed household and investment 
demand caused imports to fall further than exports. 
The  underlying  merchandise  export  performance 
remained constrained by the unfavourable external 
environment, the low competitiveness of domestic 

(6)  Croatia  was  downgraded  to  ‘speculative’  rating  by  the 
major three credit rating agencies in less than a year.  It is 
now rated two notches below investment rating by S&P at 
BB,  and  one  notch,  BB+  and  Ba1,  by  respectively  Fitch 
and  Moody’s.  In  February  2014,  Fitch  has  changed  its 
outlook  on  the  rating  to  ‘negative’  from  ‘stable’,  citing 
weak growth prospects and deteriorating fiscal position. 

15 

 
                                                           
 
                                                           
2. Macroeconomic Developments 

Graph 2.6: Gross external debt

50

40

30

20

10

0

n
b
R
U
E

120

100

80

60

40

20

0

P
D
G

f
o
%

Government
Other sectors
Total (rhs)

Credit institutions
Direct investment

Source: HNB; Commission services 

Financial sector 

are 

sector 

Problems  in  the  real  economy  are  denting 
performance.  Depressed 
banking 
economic  activity  has  translated  into  weak  credit 
demand  resulting  in  contracting  credit  to  both 
households and corporates since mid-2012. Supply 
factors also played a role in the credit contraction, 
as  lenders  focused  on  limiting  risks  and  cleaning 
rapidly  deteriorating  balance  sheets,  which  may 
hinder  investment  in  the  real  sector.  The  share  of 
non-performing loans (NPLs) to the private sector 
stood  at  15.6%  at  the  end  of  2013  chiefly  due  to 
NPLs  in  excess  of  28%  in  the  corporate  segment. 
Households  have  also  fallen  behind  in  their  debt-
servicing,  although  at  a  more  gradual  pace. 
Households 
by 
unemployment  trends  and  adverse  exchange  rate 
effects  related  to  Swiss  franc-denominated  loans. 
Interest  rates  on  such  loans  are  subject  to  a  cap 
from 2014. While these developments are intended 
to  make  repayments  more  affordable,  they  dent 
bank  profitability  and  may  distort  incentives. 
Capital  buffers  nevertheless  remain  sufficient  and 
level  of 
the  sector  maintains  and  adequate 
liquidity.  The  central  bank  has  macro-prudential 
policies  in  place  to  mitigate  the  build-up  of  new 
risks.  The  dominant  foreign  ownership  of  banks 
reduces  potential  contingent  liabilities  for  the 
sovereign. Feedback loops with the real and fiscal 
sectors could, however, intensify, due to the banks' 
increasing  holdings  of  government  securities  and 
lending to state-owned enterprises. 

particularly 

affected 

goods  and  the  restructuring  of  key  export  sectors 
(notably  shipbuilding).  After  a  sharp  decline  in 
2009, exports of services, especially tourism, have 
recovered  well,  benefiting  from  positive  global 
trends as well as diversion of tourist flows arising 
from  political  instability  in  North  Africa  and  the 
Middle East. 

Graph 2.5: Current account and components

P
D
G

f
o
%

20

15

10

5

0

-5

-10

-15

-20

-25

-30

00 01 02 03 04 05 06 07 08 09 10 11 12 13*

Trade in goods, net
Income, net
Current account

Trade in services, net
Current transfers, net

Source: HNB; * - Commission  Winter 2014 forecast

On the financing side, net FDI declined sharply 
from  8.9%  of  GDP  in  2008  to  around  2.4%  in 
2012. The investment potential in the banking and 
real  estate  sectors  has  been  largely  exhausted  and 
other sectors have not established investor-appeal, 
despite  the  accession  to  the  EU,  so  a  further 
in  2013.  Worsening 
decline  was 
the  poor  business 
macroeconomic  prospects, 
climate, restrictive labour legislation, and the high 
degree of policy uncertainty also deter investors. 

recorded 

Significant government borrowing counteracted 
bank  and  corporate  deleveraging  to  maintain 
the  country’s  gross  external  debt  above  100% 
of  GDP  (Graph  2.6).  High  external  financing 
needs  make  the  country  vulnerable  to  external 
shocks and exchange rate risks. The latter seems to 
be  mitigated  by  the  central  bank’s  focus  on 
maintaining a stable exchange rate against the euro 
and  a  stable  international  reserve  stock,  covering 
more  than  8  months  of  (albeit  cyclically  low) 
imports at the end of 2013. 

16 

 
 
 
 
 
 
 
 
 
2. Macroeconomic Developments 

Table 2.1:
Key economic, financial and social indicators - Croatia

Real GDP (yoy)
Private consumption (yoy)
Public consumption (yoy)
Gross fixed capital formation (yoy)
Exports of goods and services (yoy)
Imports of goods and services (yoy) 
Output gap

Contribution to GDP growth:
Domestic demand (yoy)
Inventories (yoy)
Net exports (yoy)

Current account balance BoP (% of GDP)
Trade balance (% of GDP), BoP
Terms of trade of goods and services (yoy)
Net international investment position (% of GDP)
Net external debt (% of GDP)
Gross external debt (% of GDP)

Private credit flow (consolidated, % of GDP)
Private sector debt, consolidated (% of GDP)

Deflated house price index (yoy)

Total Financial Sector Liabilities, non-consolidated (yoy)

Employment, persons (yoy)
Unemployment rate
Long-term unemployment rate (% of active population)
Youth unemployment rate (% of active population in the same age group)
Activity rate (15-64 years)
Young people not in employment, education or training (% of total population)
People at-risk poverty or social exclusion (% total population)
At-risk poverty rate (% of total population)
Severe material deprivation rate (% of total population)
Persons living in households with very low work intensity (% of total population)

GDP deflator (yoy)
Harmonised index of consumer prices (yoy)
Nominal compensation per employee (yoy)
Labour Productivity (real, person employed, yoy)
Unit labour costs (whole economy, yoy)
Real unit labour costs (yoy)
REER (ULC, yoy)
REER (HICP, yoy)

General government balance (% of GDP)
Structural budget balance (% of GDP)
General government gross debt (% of GDP)
Source:  Eurostat, ECB, AMECO

2007
5.1
6.5
5.0
7.1
3.7
6.1
4.9

6.6
-0.1
-1.5

-7.2
-7.0
1.1
-92.8
37.1
77.1

2008
2.1
1.4
-0.2
8.7
1.7
4.0
5.1

3.1
0.3
-1.3

-9.0
-8.0
1.1
-75.3
47.3
86.3

17.8
103.8

17.6
117.3

8.8

24.1

3.5
9.6
5.9
24.0
63.4
11.3
.
18.0
.
.

4.1
2.7
5.7
1.5
4.1
0.0
2.8
0.4

.
.
.

-2.0

-9.7

1.1
8.4
5.3
21.9
63.2
10.1
.
17.3
.
.

5.7
5.8
6.9
1.0
5.8
0.1
4.1
3.9

.
.
.

2009
-6.9
-7.5
0.4
-14.2
-16.2
-21.4
-2.2

-8.2
-2.6
3.9

-5.2
-3.4
1.3
-87.8
58.3
100.6

5.3
128.0

2010
-2.3
-1.3
-2.1
-15.0
4.8
-2.8
-3.4

-5.0
-0.3
2.9

-1.3
0.0
0.4
-96.3
62.4
105.5

8.2
137.0

2011
0.0
0.2
-0.6
-6.4
2.0
1.3
-1.9

-1.3
1.0
0.3

-0.9
0.1
0.7
-92.0
61.9
104.5

-0.1
134.2

2012
-2.0
-2.9
-0.8
-4.6
0.4
-2.1
-2.4

-2.9
-0.3
1.1

-0.1
0.9
0.0
-89.4
59.8
102.4

-2.1
132.0

-6.7

-9.5

-6.1

-2.4

5.0

4.7

2.0

0.9

-1.8
9.1
5.1
25.1
62.4
11.9
.
17.9
.
.

2.9
2.2
1.0
-5.2
6.6
3.6
1.6
1.5

-5.3
-4.4
36.6

-5.1
11.8
6.7
32.6
61.4
14.9
30.7
20.5
14.3
13.7

0.8
1.1
1.9
3.0
-1.1
-1.9
-2.1
-3.4

-6.4
-5.0
44.9

-2.3
13.5
8.6
36.1
60.8
15.7
32.3
21.3
14.8
15.4

2.0
2.2
3.0
2.4
0.7
-1.3
-1.7
-2.7

-7.8
-7.0
51.6

-3.9
15.9
10.3
43.0
60.5
16.7
32.3
20.5
15.4
16.2

2.0
3.4
3.2
2.0
1.2
-0.8
-3.4
-2.5

-5.0
-4.0
55.5

Forecast
2014
0.5
-0.5
0.3
2.0
2.5
1.7
-1.5

2015
1.2
0.5
0.5
4.0
3.0
3.2
-0.9

0.2
0.0
0.3

1.3
1.1
1.0
.
.
.

.
.

.

.

-0.2
17.6
.
.
.
.
.
.
.
.

1.4
1.3
1.0
.
0.3
-1.1
-0.4
0.5

-5.4
-5.7
67.4

1.2
0.0
0.0

0.9
1.2
0.5
.
.
.

.
.

.

.

0.5
17.2
.
.
.
.
.
.
.
.

1.8
1.5
1.8
.
1.1
-0.6
-0.1
-0.6

-4.8
-5.0
68.7

2013
-0.7
-0.7
0.0
-0.3
-1.3
-0.7
-2.2

-0.5
0.0
-0.3

0.8
0.5
0.7
.
.
.

.
.

.

.

-2.5
17.6
.
49.9
.
.
.
.
.
.

1.9
2.3
2.2
.
0.4
-1.4
0.0
1.3

-6.0
-4.7
64.9

17 

 
 
 
            
 
 
3. 

IMBALANCES AND RISKS 

3.1. 

EXTERNAL 
COMPETITIVENESS ISSUES 

SECTOR  ANALYSIS  AND 

the 

inflows 

Strong  capital  inflows  up  to  the  2008  global 
financial crisis were to a large extent directed to 
and  channelled  through  Croatia's  banking 
sector.  As  in  regional  peer  economies,  these 
inflows were the driving force of Croatia's growth. 
However,  the  sizeable  foreign  direct  investment 
(FDI) 
tradable 
largely  by-passed 
sector.  In  fuelling  domestic  demand,  capital 
the  current  account  deficit, 
inflows  widened 
contributing 
internal  and 
external debt and price pressures. By 2008, Croatia 
had accrued gross external debt in excess of 100% 
of  GDP  but  had  invested  only  a  small  part  in 
economic 
productive 
assets 
transformation.  Consequently, 
domestic 
economy  is  now  in  a  period  of  forced  balance 
sheet repair which weighs on growth (see Section 
3.2.).  

the  build-up  of 

and 
the 

domestic 

to 

Subsection  3.1.1.  presents  the  dynamics  and  the 
financing  of  the  current  account  and  the  net 
international 
(NIIP)  and 
investment  position 
discusses external vulnerabilities. Subsection 3.1.2. 
explores the underlying export performance, which 
is  very  weak  for  merchandise,  and  examines  the 
distinct  roles  of  cost-competitiveness,  the  labour 
market, the business environment and FDI.  

3.1.1.  External sector trends 

The expansionary phase 

The converging Croatian economy ran sizeable 
current  account  deficits  from  2000  to  2008. 
Consumption  and  investment  exceeded  domestic 
production  and  savings,  resulting  in  an  average 
current  account  deficit  of  5.5%  of  GDP  over  the 
period. Surging investment pushed the deficit close 
to  9%  of  GDP  in  2008  (see  Graph  3.1).  The 
negative trade balance, reflecting a strong deficit in 
goods  trade,  accounted for  the  bulk of  the  deficit. 
This  was  partially  compensated  by  the  surplus 
from trade in services arising from the large tourist 
sector (see Graph 3.2).  

Graph 3.1: Current account composition

20

10

0

-10

-20

-30

P
D
G

f

o
%

8

4

0

-4

-8

P
D
G

f

o
%

-12

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13*

Capital account (KA)
Current transfers
Income balance
   Balance of services
   Balance of goods
Trade balance
Current account balance (CA)
Net lending/borrowing (CA+KA)

Source: Eurostat; Commission services; * estimate

Graph 3.2: Exports and Imports

100

50

0

-50

s
e
c
i
r
p

5
0
0
2
t
a
,
n
B
K
R
H

-100

-150

0
0

1
0

2
0

3
0

4
0

5
0

6
0

7
0

8
0

9
0

0
1

1
1

2
1

*
3
1

*
4
1

*
5
1

Imports of services
Exports of services
Trade balance

Imports of goods
Exports of goods

Source: Eurostat; Commission services; * - forecast

Large  deficits  were  mainly  financed  by  robust 
FDI inflows. Annual average net FDI amounted to 
nearly  5%  of  GDP  in  the  period  2000-2008, 
the  current 
covering  approximately  90%  of 
account  deficit.  Privatisations  and 
follow-up 
investments  by  parent  companies  were  key 
determinants  of  FDI  (see  Graph  3.3).  Other 
investments,  principally 
to 
corporates  and  foreign  banks’  deposits,  were  of  a 
broadly  equal  magnitude  to  the  FDI  flows  in  the 
years preceding the crisis. 

long-term 

loans 

19 

 
 
 
 
 
 
 
 
 
 
 
3. Imbalances and Risks 

recession has caused an abrupt fall in imports. The 
drop  in  imports  of  capital  goods  was  particularly 
pronounced,  mirroring  very  weak 
investment 
activity  amid  corporate  balance  sheet  repair  (see 
also  Section  3.2.).  Goods  exports  fell  in  absolute 
terms  over  the  period,  but  exports  of  services 
rebounded  due  to  tourism,  which  benefited  from 
diversion  of  tourist  flows  from  North  Africa  and 
the  Middle  East.  Despite  the  severity  of  the 
downturn in Croatia, the current account swing has 
been  of  an  average  magnitude  for  the  region 
(Graph 3.5). 

Graph 3.5: Current account adjustment in 
selected Member States

30

20

10

0

-10

-20

-30

BG LV LT EE RO SI HU HR SK PO CZ

2007-08 low 2013*

change, pps

Source: Eurostat; Commission services; * - forecast

transformed 

the  external 
The  downturn 
financing  of  the  economy.  Annual  average  net 
FDI flows plummeted to 2% of GDP in the 2010-
13 period, from around 6% of GDP between 1999 
and  2008.  An  even  stronger  contraction  was 
recorded  in  long-term  borrowing  reflecting  on-
going  deleveraging  by  banks  and  corporates  (see 
also  Section  3.2.) (8).  A  change  in  the  financing 
patterns  of  businesses,  from  foreign  to  domestic 
sources,  was  also  evident.  At  the  same  time, 
portfolio  investments  increased  as  a  result  of 
foreign borrowing by the state. 

The  headline  current  account  is  expected  to 
remain in surplus in the near future. Investment 
is  set  to  remain  subdued  and  household  demand 
will be under pressure from negative labour market 
developments.  At  the  same  time,  the  gradually 
improving 
potential 
efficiency  gains  as  a  result  of  the  industrial 

external 

outlook 

and 

(8)  In  2012  alone,  "other  investments"  recorded  net  outflows 
of  some  5.5%  of  GDP  that  arose  from  both  debt 
repayments  by  companies  and  withdrawal  of  deposits  by 
banks. 

Graph 3.3: Current account financing

10

5

0

-5

-10

-15

-20

P
D
G

f

o
%

99 00 01 02 03 04 05 06 07 08 09 10 11 12
Portfolio investment, equity securities (net)
Net errors and omissions
Official reserves (net)
Other investment (net)
Portfolio investment, debt securities (net)
Direct investment (net)
Current account balance (rhs)

Source: Eurostat

The  economy's  stock  of  foreign  liabilities  grew 
more  than  five-fold  between  2000  and  2007. 
Private  capital  inflows,  together  with  negative 
valuation  effects  due  to  rapidly  growing  asset 
prices, contributed to a surge in the NIIP from 17% 
of  GDP  at  the  end  of  2001  to  93%  at  the  end  of 
2007 (Graph 3.4). (7) These financing flows, while 
increasing  gross  external  debt,  also  enabled 
significant accumulation of international reserves. 

Graph 3.4: Net IIP

50

0

-50

-100

-150

P
D
G

f
o
%

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Net portfolio investment, equity securities
Net portfolio investment, debt securities
Changes in reserves (net)
Other investment (net)
Net direct investment
Net external debt (neg. sign)
Net int'l investment position (NIIP)

Source: Commission services; Eurostat

The prolonged downturn 

From  a  deficit  of  8.8%  of  GDP  in  2008,  the 
current  account  swung  into  a  small  surplus  in 
2013.  Falling  domestic  demand  through  the  long 

(7)  The  discontinuity  in  2008  arises  due  to  a  one-off  positive 

re-valuation of the FDI stock 

20 

 
 
 
 
 
 
 
                                                           
 
 
                                                           
restructuring  taking  place  in  the  last  few  years  in 
legacy 
industries  such  as  shipbuilding  and 
chemicals may stem the decline in exports.  

Vulnerabilities 

in 

trends 

The  closing  of  the  current  account  has  not 
improved  Croatia’s  external  liability  position. 
The  NIIP  is  gently  reducing  from  around  90%  of 
GDP  as  the  result  of  valuation  changes  and  two 
opposing 
transactions:  a  gradual 
reduction  in  the  stock  of  corporate  and  banking 
sector  liabilities  and  an  increase  in  portfolio 
borrowing,  in  particular  by  the  state  (Graph  3.6). 
This relative stability belies significant refinancing 
pressures  for  banks  and  corporates  and  mounting 
refinancing  risks  for  the  state.  Absent  strong 
nominal  GDP  growth,  which  would  accelerate 
private  balance  sheet  repair,  curtail  sovereign 
borrowing needs and ease the external debt burden, 
current  trends  in  transactions  and  valuations  are 
not going to substantially reduce the NIIP. 

Graph 3.6: Decomposition of rate of change of 
NIIP

)
y
-
o
-
y
(

P
D
G

f
o

.
p
p
n

i

e
g
n
a
h
C

30

20

10

0

-10

-20

-30

-40

05Q4

07Q1

08Q2

09Q3

10Q4

12Q1

13Q2

Valuation changes
Investment income effect
Change in NIIP

Net transaction effect
Nominal growth effect

Source: Commission services; Eurostat

The  high  stock  of  FDI  mitigates  Croatia's 
exposure to sudden reversals in financial flows. 
Direct  investments  accounted  for  50%  of  foreign 
liabilities at the end of 2008 (see Graph 3.7 ). The 
share  of  direct  investments  held  by  non-residents 
has since slightly receded due to valuation effects. 
On the asset side, international reserves have been 
on  an  upward 
the 
recession  period  when  private  capital  inflows 
abated.  Sizeable  assets  accumulated  in  the  non-
banking  financial  sector,  in  particular  in  pension 
funds,  are  set  to  play  an  increasing  role  in  NIIP 
developments. 

trend  continuing 

through 

3. Imbalances and Risks 

Graph 3.7: Gross IIP - liability-side breakdown 
% of total

100

80

60

40

20

0

2000

2008

2012

FDI

Portfolio Other

Source: Commission services; HNB

: 

However,  the  high  level  of  gross  external  debt 
requires  close  monitoring.  Reduced  external 
exposure  of  financial 
institutions  and  public 
companies has brought gross external debt slightly 
below  the  2011  peak  level  of  105%  of  GDP  (see 
Graph  3.8  ). (9)  These  trends  would  have  brought 
about  a  steeper  decline,  were  it  not  for  rising 
foreign borrowing by the sovereign and increasing 
cross-border,  inter-company  lending.  Since  the 
start of the crisis, the share of public external debt 
rose  by  7  percentage  points  to  reach  34%  of  total 
external  debt  at  the  end  of  October  2013.  A 
commensurate  drop  was  recorded  in  the  share  of 
private  foreign  debt  (excluding  inter-company 
lending) in line with the gradual deleveraging. 

Graph 3.8: Gross external debt per sector

120

100

P
D
G

f
o
%

80

60

40

20

0

Public

Private

Direc investments

Source: Commission services; HNB

(9)  A shift in financing from foreign to domestic sources is the 
underlying factor for the fall in the stock of gross external 
debt of public companies. 

21 

 
 
 
 
 
 
 
 
 
 
 
                                                           
3. Imbalances and Risks 

High  external  repayment  needs  remain  an 
important vulnerability. Projected gross external 
debt  repayments  for  2014  exceed  20%  of  GDP, 
the  private  sector. 
predominantly  falling  on 
Intercompany  loans  and  financing  from  parent 
banks, i.e. two types of debt that are usually more 
easily  re-financeable,  account  for  a  considerable 
portion of due debt for corporates and banks (close 
to  12%  of  GDP).  Nevertheless,  a  worsening  in 
external 
the 
emergence  of  liquidity  constraints  or  a  rise  in 
borrowing  costs,  for  instance  through  changes  in 
risk  premia,  could  affect  refinancing  possibilities. 
As  for  the  sovereign,  2014  foreign  debt  re-
financing needs have been covered to some extent, 
although at high borrowing costs, thus contributing 
to a steep increase of the interest payment bill and 
a deterioration of the fiscal position.   

financing  conditions 

such  as 

3.1.2.  External Competitiveness 

Export performance 

The sudden halt of private capital inflows with 
the  2008  global  financial  crisis  brought  to  the 
surface  Croatia’s  weak  competitiveness.  High 
investment (and borrowing) rates before the crisis, 
including  significant  FDI,  did  not  result  in  strong 
export performance. Croatia has been losing export 
market shares since 2004 and there was has been a 
particular intensification in these losses since 2008 
(see Graph 3.9, note the large relative increases in 
the first years start from a very low base). Greater 
sustainability  of  Croatia's  external  position  is 
conditioned  on  improved  competitiveness  and 
ability to export. 

Graph 3.9: Export market share decomposition

25

20

15

10

5

0

-5

-10

-15

-20

)

%

(

y
-
o
-
y
e
g
n
a
h
c

f
o
e
t
a
R

00 01 02 03 04 05 06 07 08 09 10 11 12

Contribution to EMS: goods
Contribution to EMS: services
Export market share growth yoy

Source: Commission services; Eurostat

22 

Croatia's  export  performance  lags  significantly 
behind that of its peers. All new Member States 
from Central and Eastern Europe (CEE10) register 
higher  export  growth  and  latterly  even  the  more 
mature  euro  area  economy  is  outstripping  Croatia 
(Graph  3.10). (10)  The  divergence 
trade 
performance  becomes  particularly  visible  in  the 
post-2008  period.  While  exports  of  the  CEE10 
(with  the  exception  of  Slovenia)  managed  to 
recover  strongly  from  the  one-off  slump  in  2009, 
Croatia’s  volume  of  exports  was  10%  below  its 
2012. 
level 
2008 

peak 

in 

in 

Graph 3.10: Volume of exports of goods and 
services

0
0
1
=
0
0
0
2

260

240

220

200

180

160

140

120

100

2000

2002

2004

2006

2008

2010

2012

Croatia

CEE10

EU 17

Source: Commission services calculations; Eurostat

Weak  goods  exports  are  central  to  Croatia's 
poor overall export performance. This is evident 
from  Graph  3.10  above  and  examined  in  greater 
detail  in  Box  3.1.  In  the  last  13  years,  goods 
exports have remained stable at 22% of GDP. This 
is in marked contrast with the expansion recorded 
in  CEE10  (from  46%  of  GDP  in  2000  to  62%  of 
GDP  in  2012).  Goods  account  for  around  half  of 
for 
Croatia's  exports,  with 
machinery,  electrical,  chemical  and  mineral 
products. 

sizeable 

shares 

One-off factors explain some of the more recent 
declines.  As  described 
in  Box  3.1,  specific 
industries as well as some export markets account 
for  the  bulk  of  the  most  recent  declines.  The 
shipbuilding  sector,  Croatia’s  once  leading  export 
industry,  is  currently  in  restructuring.  The  exit 

(10)  These  include  Bulgaria,  the  Czech  Republic,  Estonia, 
Hungary,  Latvia,  Lithuania,  Poland,  Romania,  Slovakia, 
Slovenia. 

 
 
 
 
 
 
 
 
                                                           
3. Imbalances and Risks 

succeeded  in  maintaining  external  sustainability 
after early success in the tourism market.    

from  the  CEFTA  area  implies  reduced  access  to 
some  regional  markets,  in  particular  Bosnia  and 
Herzegovina,  Croatia's  second 
largest  export 
market  and  one  in  which  Croatian  producers 
enjoyed  competitive  advantages. (11)The  tourism 
sector  has  shown  some  resilience  but  this  has 
not  sufficed  to  stem  the  decline  in  overall 
exports.  Tourism  already  accounts  for  a  third  of 
Croatia's  exports  (and  two  thirds  of  services 
exports). (12)  Services  exports,  led  by  tourism, 
fared  better  than  goods  exports  over  the  past  13 
years  period 
(see  Graph  3.12),  but  also 
underperformed  when  compared  with  new 
Member  States,  especially  during  the  post-boom 
cycle. 

Graph 3.12:Value of exports of travel services

260

240

220

200

0
0
1
=
0
0
0
2

180

160

140

120

100

80

00 01 02 03 04 05 06 07 08 09 10 11 12

BG

EL

ES

HR

PT

SI

Source: Eurostat;Commission services calculations

in 

the 

Growth  in  tourism  will  become  challenging  to 
term.  Substantial 
maintain 
longer 
development  beyond  summer  tourism  could  only 
be  pursued  with  significant 
investment.  The 
absence  of  seasonal  complementarities  with  other 
industries causes significant volatility in the labour 
market. To lengthen the season and attract higher-
spending  tourists,  the  sector's  competitiveness 
would  also  need  to  be  improved  across  several 
dimensions 
that 
realistically  can  only  be  achieved  with  sustained 
effort  over  long  periods.  Regional  peers  with 
similar  natural  endowments  have  not  always 

(see  Heatmap),  a  process 

(11)  Holzner, M. (2013), “Impact of Croatian EU Accession on 
Regional  Trade  Patterns”,  wiiw  Policy  Note  No.  10,  June 
2013 

(12)  Germany  is  the  top  market  and  has  remained  strong,  with 
tourists  from  Germany  accounting  for  almost  a  quarter  of 
overnight stays. 

23 

 
 
                                                           
3. Imbalances and Risks 

Heatmap: 
Dimensions of Competitiveness 

Tourism  Ratings  Across  Five 

HR

EL

IT

CY

MT

PT

ES

4.65
Business environment
5.02
Travel & tourism regulatory framework
4.58
Human, cultural and natural resources
4.22
Policy, rules and regulations
Price competitiveness
3.59
Source: WEF Travel and Tourism Competitiveness Report 2013

4.43
4.99
4.37
4.24
4.01

4.76
4.9
5.05
4.21
3.4

4.89
5.35
4.27
4.33
4.21

5.06
5.47
4.22
4.57
4.32

4.78
5.42
4.84
4.72
4.04

5.3
5.48
5.36
4.52
4.11

24 

 
 
 
 
 
 
 
 
3. Imbalances and Risks 

Box 3.1: Croatia’s declining goods exports

This  box  examines  the  trends  in  market  shares  by  sectoral  and  geographic  destination  of  goods  exports. 
Croatia was able to capitalise on its initial specialisation and increase its market shares in the period 2000-
2008 as a result of high growth in  2001 and 2003. This situation was reversed in 2008-2010, when initial 
geographic specialisation and losses in specific sector market shares dragged down export performance (see 
Graph 1). (1) Indicatively, two thirds of the decline can be attributed to losses in competitiveness. 

Graph 1:Geographical and sectoral decomposition of goods export market shares

12

10

8

6

4

2

0

-2

-4

-6

-8

)

%

(

e
t
a
r

e
g
a
r
e
v
a

c
i
t
e
m
h
t
y
r
a

l

a
u
n
n
A

2000-2008

2008-2012

Market share gains in product markets
Market share gains in geographical destinations
Initial product specialisation
Intial geographical specialisation

Source: COMTRADE data (HS 1992 commodity classification); 
Commission services calculations

i.  Proximity  to  and  therefore  reliance  on  the  depressed  Italian,  Bosnian  and  Slovenian  markets  were  a 
significant drag on exports in 2008-2012 (see Graph 2a). This was compounded by market share losses in 
Italy and Bosnia. There were no dynamic markets among Croatia's top-10 export destinations.  

ii. Heavy reliance on depressed sectors including machinery, metals and vessels undermined overall export 
performance  in  2008-2012  (see  Graph  2b).  This  was  coupled  with  loss  of  competitiveness  in  moderately 
more dynamic sectors such as foodstuffs and minerals. The drag from these trends far exceeded the isolated 
gains in the chemicals and agriculture sectors.  

For 2013, the available data point to an absolute decline in nominal goods exports of the order of 6%. (2) 
Two  thirds  of  this  decline  is  attributable  to  'other  transport  equipment'  (mainly  ships)  –  a  sector  that  has 
registered a cumulative drop of around 80% over two years. The other major  weaknesses appear in sugar, 
metal  ores,  petrol,  fertilisers,  telecommunications  equipment,  electrical  machinery,  apparel  and  –  carried 
forward from 2012 – plastics. Strong growth was only registered in the export of electric current, which may 
be  weather-related.  The  concentration of  weak  performance  in  a  few  sectors  suggests  specific  supply-side 
dislocations are playing an important role, compounding the overall competitiveness deficit. 

(1)  This  exposition  attributes  the  change  in  export  market  shares  to  dynamism  (growth  or  decline)  of  geographic  and 
product markets and residuals that reflect market share gains (or losses) in those geographic or product markets. For 
methodology, see ch. 3, QREA 2/2012. 

(2)  According  to  Eurostat  data  to  October  2013  for  intra  and  extra  EU  goods  exports  in  Euros.  The  data  needed  to 

calculate market shares are not yet available for 2013. 

(Continued on the next page) 

25 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                           
 
 
 
3. Imbalances and Risks 

Box (continued) 

Graph 2a: Dynamism and competitiveness of 
top-10 goods export destinations(2008-2012)

Graph 2b: Dynamism and competitiveness of 
top-10 goods export destinations 
(2008-2012)

US

NL

RU

UK

DE

AT

HU

SI

IT BiH

)
p
p
(

i

m
s
m
a
n
y
D

t
e
k
r
a
M

22

17

12

7

2

-3

-8

17

4

5
11
20

16

2

6

9
15

)
p
p
(

i

m
s
m
a
n
y
D

t
e
k
r
a
M

2

0

-2

-4

-6

-8

-10

-12

-18

-8

2

12

22

Competitiveness (pp)

Source: COMTRADE; Commission services; Bubble size 
varries directly with destinations's share in Croatia's goods 
exports

Underlying competitiveness position 

Croatia has been, and remains, a comparatively 
expensive  production  location.  Croatian  labour 
costs  already  exceeded  those  of  most  regional 
competitors in 2000. Along with Slovenia, Croatia 
has sustained relative labour cost levels that  more 
than  proportionately 
labour 
productivity (Graph 3.13). 

reflected  higher 

30

28

26

24

22

20

18

16

14

12

10

S
P
P

,
)
3
1
0
2
-
9
0
0
2

e
g
a
r
e
v
a
(
e
e
y
o
p
m
e

l

r
e
p
n
o
i
t
a
s
n
e
p
m
o
C

Graph 3.13:Compensation and productivity

SI

HR

CZ

EE

HU

PL
LT

SK

LV

RO

BG

20

30

40

50

GDP per employee (average 2009-2013), PPS

Source: Commission services (AMECO)

Nominal  unit  labour  costs  (ULC)  have  evolved 
moderately,  albeit  from  a  high  starting  point. 
Since  2000,  wage  and  productivity  developments 
have  yielded  ULC  growth  slightly  higher  than  in 
the euro area, but lower than in the faster-growing 

26 

-32

-12

8

28

Competitiveness (pp)

Source: COMTRADE; Commission services; Bubble size varies directly 
with sectors's share in Croatia's goods exports; Key: 2=agriculture; 
4=foodstuff &tobacco; 5=mineral products; 6=chemical products; 
9=wood&cork; 11=textiles; 15=metals; 16=machinery &electrical; 
17=vehicles; 20=miscellaneous

competitors in Central and Eastern Europe (Graph 
3.14). (13) 

Graph 3.14: Nominal ULC

0
0
1
=
0
0
0
2

190

170

150

130

110

90

CEE 3*
HR

Baltics
euro area

SI

Source: Commission services calculations; Eurostat; * - SK, 
CZ, HU

Overall,  Croatia's  uncompetitive  positioning 
has  remained  largely  unimproved.  Nominal 
ULC and productivity developments have resulted 
in  a  declining  wage  share  in  both  Croatia  and  the 

(13)  Croatia  may  however  have  achieved 

less  quality 
improvement  in  its  exports  to  compensate  cost  increases. 
Benkovskis  and  Woerz  (2012)  find  that  loss  in  price/cost 
competitiveness  in  1999-2011  for  the  CEE10  was  more 
than  offset  by  gains  in  non-price  competitiveness,  in 
particular  due  to  improvements  in  quality  (physical  and 
intangible).  Unlike  in  the  CEE10,  quality  gains  does  not 
seem  to  have  played  a  significant  role  for  Croatia’s 
manufacturer exports in 2000-2007, as found out by Stojcic 
et al (2012). 

 
 
 
 
 
 
 
                                                           
 
 
 
 
 
 
 
CEE10  (see  Graph  3.15).  The  wage  share  in 
Croatia remains rather close to that of the euro area 
overall,  whereas  its  industrial  structure  differs 
markedly and its level of human capital and human 
capital utilisation is lower. 

Graph 3.15: Adjusted wage share

P
D
G

f

o
%

60

55

50

45

02 03 04 05 06 07 08 09 10 11 12 13* 14* 15*

EA-18

HR

CEE10

Source: Commission services; AMECO; * - projection

in 

based 

pronounced 

been  most 

The  damage  to  cost-competitiveness  seems  to 
the 
have 
manufacturing  sector (Graph 3.17).  There  was  a 
steep worsening of the real effective exchange rate 
(REER) 
in 
on  ULC 
manufacturing.  This  contrasts  sharply  with  the 
usual  pattern  of  declining  manufacturing  ULC 
observed 
economies,  where 
productivity gains play a role, and in fast-adjusting 
economies.  Relatively  high  labour  cost  and  low 
productivity  levels  may  account  for  some  of  the 
poor goods export performance detailed above and 
in Box 3.1. 

competing 

dynamics 

in 

time, 

that  cost  adjustment 

is 
There  are  signs 
beginning  to  take  place.  Over 
these 
reductions  may  facilitate  the  reorientation  of  the 
economy  towards  external  demand.  However, 
export  market  share  losses  have  been  gathering 
in  cost-
pace  even 
competitiveness 
the 
degree  of  remaining  cost  misalignment  and  may 
also  indicate  impacts  from  additional,  non-cost-
competitiveness factors. 

trends.  This  may  reflect 

turnaround 

since 

the 

3. Imbalances and Risks 

Graph 3.16: ULC-deflated REER

140

130

120

110

100

90

0
0
1
=
0
0
0
2

HR, total economy

CEE10 average, total economy

Source: Price and Cost Competitiveness report, DG ECFIN

Graph 3.17: REER deflated for nominal wage 
costs in manufacturing

0
0
1
=
0
0
0
2

160

150

140

130

120

110

100

90

00 01 02 03 04 05 06 07 08 09 10 11 12

HR, manufacturing

CEE10 average, manufacturing

Source: Price and Cost Competitiveness report, DG ECFIN

The role of the labour market 

Croatia  has  recorded  the  lowest  employment 
rates  in  the  EU  since  2010.  Even  during  the 
expansionary  phase  of  the  cycle,  the  employment 
rate (for age 15-64) never exceeded 58% and was 
always  one  of  the  four  lowest  among  the  (now) 
EU28; by 2012 the employment rate had fallen to 
52.4%.  Unemployment  rates  dipped  into  single 
digits only briefly during the boom years. Lack of 
competitiveness  constrained  hiring 
in  export-
oriented  industries,  typically  an  engine  of  job 
creation  in  the  region.  Unsurprisingly,  the  large 
employment  gap  widened  further  during 
the 
recession.  In  addition  to  the  social  consequences, 
low  employment  impinges  on  fiscal  sustainability 
and,  through  potential  output,  on  overall  external 
sustainability. 

27 

 
 
 
 
 
 
 
3. Imbalances and Risks 

legislation,  although  not  very  stringent  in  EU 
comparison (16),  may  nevertheless  hinder 
job 
creation,  given  Croatia's  current 
stage  of 
development  and  mounting  adjustment  needs  (see 
Box  3.2.)  although  this  may  be  addressed  by  on-
going  reform  efforts.  Furthermore,  the  de  jure 
flexibility  of  employment 
legislation  can  be 
undermined by legal uncertainty and court delays. 
Finally, low recorded employment may also reflect 
a  sizeable  grey  economy (17),  which  is  also  a 
feature  of  neighbouring  countries  and  of 
economies dominated by seasonal work. 

The  role  of  the  business  environment  and 
product markets 

functioning,  prolonged 

Croatia's  business  environment  is  marked  by 
multiple  shortcomings  that  may  dent  its  cost 
and  non-cost  competitiveness  as  well  as  the 
performance  of 
the  domestically-oriented 
economy. Among these, a high regulatory burden, 
inefficiencies in the administration of construction 
permits  and  property  registration,  poor  justice 
system 
litigation  and 
bankruptcy  procedures (18),  weak  protection  of 
investments,  high  policy  uncertainty (19),  weak 
corporate  governance,  insufficient  know-how  in 
marketing  local  produce  stand  out  as  significant 
bottlenecks. (20) Several surveys place the country 
amongst  the  worst  EU  performers  in  terms  of 
business  climate  and  competitiveness  (see  Graphs 
3.18-3.20). While structural features such as these 
tend  to  exhibit  significant  persistence,  they  may 
interact  with  investment,  particularly  FDI,  to 
explain worsening export performance. 

(16)  Legislation in the  EU as a  whole is  generally stricter than 

in other OECD countries. 

(17)  See Schneider (2013) 
(18)  Public  administration  as  a  whole  scores  relatively  poorly 
Indicators 

the  Worldwide  Governance 

to 

according 
produced by the World Bank. 
uncertainty 

(19)  Policy 

numerous 

legislative 
reflects 
amendments  that  are  sometimes  of  a  reverse  nature.  For 
example  the  VAT  for  the  tourist  sector  was  reduced  from 
25% to 10% as of 2013, but was then increased to 13% as 
of  2014.  On  a  related  note,  a  pre-bankruptcy  settlement 
legislation  adopted  in  October  2012  underwent  several 
changes in less than a year and a new amendments is likely 
(20)  This list is not exhaustive. For instance, while paying taxes 
does  not  register  as  a  problem  overall,  there  are  specific 
issues  affecting  SMEs  and  the  existence  of  around  550 
parafiscal levies (cut from around 600 in 2013) represents a 
significant  burden  for  businesses  (the  scrapping  of  50  of 
these is estimated to have reduced administrative burden by 
0.1% of GDP). 

The  large  public  sector  has  exerted  upward 
pressure  in  economy-wide  wage  levels.  There 
were  significant  increases  in  the  wages  of  public 
sector  employees  between  2007  and  2009. 
Compensation in the sector was additionally raised 
by  significant  increases  in  bonuses  and  other 
payments,  which  were  partly  reversed  in  mid-
2009, when the authorities scrapped a 6% increase 
in wages in the public administration that had been 
introduced  at  the  beginning  of  the  year.  This  was 
followed  in  2013  by  a  3%  cut  in  the  public  wage 
bill.  In  the  business  economy,  labour  costs  have 
followed  the  economic  cycle  somewhat  more 
closely, declining from 35% of the EU average in 
2008 to reach 30% in 2012. (14)   

from 

exposed 

abroad.  Whereas 

Significant  jobs  losses  have  been  recorded  in 
to  actual  or  potential 
sectors 
job 
competition 
destruction  was  largely  the  consequence  of  the 
downsizing  of  some  non-tradable  sectors  to  more 
sustainable  levels  (e.g.  construction),  sharp  job 
losses  were  also  recorded  in  manufacturing.  This 
indicates  clear  weaknesses  in  sectors  that  are  or 
could  potentially  be  in  competition  with  abroad 
and  adds  to  the  challenges  of  fostering  a  more 
competitive economy. 

The  institutions  underpinning  labour  market 
performance exhibit a number of shortcomings. 
The social protection system favours and provides 
multiple  avenues  for  early  withdrawal  from  the 
labour  market  and  discourages  labour  market 
participation  in  the  low-wage  sector  by  putting  a 
high  floor  under  the  reservation  wages  of  certain 
categories of beneficiaries. Unemployment benefit 
replacement  rates  for  are  low,  especially  after  3 
months,  and  duration  is  not  very  long.  However, 
transitions  into  work,  even  into  low-paid  work, 
may  still  be  disincentivised  as  a  result  of  the 
immediate  discontinuation  of  social  assistance 
thresholds. (15) 
earned-income 
above 
Adjustment 
and 
mismatches  in  the  labour  market  stand  out  as 
major bottlenecks. Current employment protection 

difficulties, 

skills 

gaps 

low 

(14)  Eurostat data 
(15)  In addition, the attribution of the different social benefits is 
scattered  among  different  services  with  little  or  no 
communication  between  them  –  including  also  local 
government, which can provide benefits on their own – and 
between  the  social  welfare  and  the  employment  services. 
This  makes  it  harder  to  coordinate  benefits  such  as  to 
promote labour supply. 

28 

 
                                                           
                                                           
3. Imbalances and Risks 

29 

 
 
 
 
 
3. Imbalances and Risks 

Box 3.2: Employment protection legislation as impediment to competitiveness

Tight  labour  regulations  can  reduce  the  pace  of  adjustment  of  employment  to  economic  activity,  i.e.,  the 
dynamics  of  job  creation  and  job  destruction  with  too  restrictive  labour  legislation  are  likely  to  lead  to 
reduced  labour  market  flows.  This  can  have  macroeconomic  consequences  particularly  at  a  time  of  rapid 
structural change. The effect on employment levels over the longer run may be more ambiguous. (1) Rigid 
employment  rules,  such  as  restrictive  hiring  and  redundancy  practices  raise  implicit  labour  costs.  Rigid 
employment protection legislation also contributes to labour-market segmentation. 

Tight employment protection legislation has been identified as a constraint for labour market adjustment in 
Croatia  (WB  2011)  and  labour  market  rigidity  has  been  highlighted  as  an  important  non-price  barrier  for 
Croatia’s  competitiveness  (see  IMF  2012  and  WB  2011).  According  to  National  Bank  of  Croatia’s 
estimates, Croatia’s employment protection legislation (EPL) index as designed by the OECD stood at 2.61 
in  mid-2013,  above  the  average  reading  for  a  group  of  peer  economies  (see  Graph  1).  Labour  market 
outcomes  are  consistent  with  segmentation,  notably  Croatia's  high  youth  unemployment,  which  rapidly 
deteriorated  during  the  crisis,  as  well  as  its  high  shares  of  long-term  unemployment  and  long  spells  of 
unemployment.  The  share  of  unemployment  spells  lasting  in  excess  a  year  was  65%  in  2012,  the  second 
highest  reading  in  the  EU  after  Slovakia.  The  considerable  underutilization  of  human  capital  in  turn 
degrades employability and productivity, particularly for vulnerable groups.   

Graph 1:Employment protection legislation index

4

3

2

1

0

Total

full-time
employment

fixed-term
employment

collective
redundancies

Croatia

Peer group*, average

Source: CNB bulletin 194 ; * - SI, PO, EE. CZ, SK and HU

In order to improve labour-market flexibility, the authorities launched a two-stage reform in 2013. The first 
set  of  amendments  to  the  labour  legislation,  which  took  effect  in  the  middle  of  that  year,  focused  on 
regulation  of  fixed-term  contracts  and  procedures  for  dismissals.  The  government  adopted  a  second 
legislative proposal in January 2014. If enacted, it will provide for reduction of dismissal costs by shortening 
and  simplifying  procedures  and  increase  working-time  flexibility.  In  addition,  more  flexible  forms  of 
employment such as part-time contracts would be introduced. Based on current information, these changes 
would result in an improvement in Croatia’s EPL index, bringing the country largely on par with its peers. 

(1)  See  European  Commission  (2012),  "Labour  Market  Developments  in  Europe",  European  Economy  5/2012  for  a 

review of macroeconomic implications of EPL.

30 

 
 
 
                                                           
 
 
 
Graph 3.18: Doing business  2014, country 
ranking

Paying taxes

Getting credit

Enforcing contracts

Getting electricity

Starting a business

Resolving insolvency

Trading across borders

Registering property

Construction permits

Protecting investors

Total

0

Source: World Bank

30
90
60
CEE10 average
Croatia

120

150

180

Graph 3.19: Economic freedom 2014 index, 
country ranking

Investment freedom

Trade freedom

Financial freedom

Monetafry freedom

Freedom from corruption

Property rights

Business freedom

Fiscal freedom

Government spending

Labor freedom

Total

0

30

60

90

120

150

180

CEE10 average
Croatia
Sources: Heritage foundation

Graph 3.20: Global competitiveness 2013-14 
index, country ranking

Infrastructure

Technological readiness

Higher education, training

Health, primary education

Macroeconomic environment

Market size

Financial markets

Innovation

Business sophistication

Institutions

Goods market efficiency

Labour market efficiency

Total

0

30

60

90

120

150

CEE10 average

Croatia

Source: World Economic Forum

3. Imbalances and Risks 

in  order 

the  areas 

Several  of 
in  which  Croatia 
underperforms the CEE10 are directly relevant 
to potential investors searching for a production 
location. This can be illustrated taking five of the 
Doing  Business  indicators  where  Croatia  scores 
poorly.  The  ease  of  trading  across  borders  is 
important  for  potential  exporters;  Croatia's  poor 
score  is  particularly  attributable  to  the  cost  of 
procedures  required 
to  ship  goods 
(amounting  to  USD  1,335  to  ship  a  notional 
container  which  compares  to  USD  1,070  on 
average  in  the  OECD).  Registering  property  and 
obtaining  construction  permits  are  important  for 
potential greenfield investors; Croatia's poor scores 
on  these  indicators  largely  stem  from  lengthy 
procedures, with registration taking 102 days for a 
notional  warehouse  project  (versus  24  days  on 
average in the OECD) and permits taking 317 days 
investors 
(141  days 
(including 
to  be  well 
protected by the law and here Croatia's poor score 
limited 
is 
disclosure 
to 
shareholders  seeking  redress.  Barriers  to  FDI  are 
also  generally  barriers  to  local  entrepreneurship, 
investment, business start-ups and job creation. 

the  OECD).  Finally, 
investors)  need 

largely  attributable 

to  directors' 

requirements 

in 
local 

obstacles 

and 

justice  system 

The  civil 
is  accumulating 
backlogs.  The  length  of  judicial  proceedings  in 
litigious  civil  and  commercial  cases  remained 
among  the  highest  in  the  EU,  although  it  was 
slightly  shortened  from  462  days  in  2010  to  457 
day  in  2012  (Disposition  Time,  CEPEJ  data). 
Despite  the  fact  that  the  courts  in  2012  resolved 
16%  more  litigious  civil  and  commercial  cases 
compared to 2010, the rising number of incoming 
cases  and  the  reduced  clearance  rate  of  95% 
contributed to the rise in backlog. Until the end of 
2012, the number of litigious civil and commercial 
pending cases rose by 15% compared to 2010, and 
remained  among  the  highest  in  the  EU  (measured 
per capita). Legislative amendments upgrading the 
role  of  the  financial  agency  FINA  appear  to  have 
improved  the  effectiveness  of  enforcement  on 
monetary  assets,  although  the  effectiveness  as 
regards  other  types  of  assets  remains  a  challenge 
(e.g.  immovable  property  where  the  recovery  rate 
appears  to  be  low).  The  length  of  proceedings  in 
land  registry  cases  was  reduced  from  50  days  in 
2010 to 42 days in 2012 (Disposition Time, CEPEJ 
data).  Compared  to  2010,  the  falling  number  of 
incoming  land  registry  cases  and  the  Clearance 
Rate of 101% resulted in a reduction of the number 

31 

 
 
 
 
3. Imbalances and Risks 

Graph 3.21: FDI inflows

10

P
D
G

f
o
%

8

6

4

2

0

Slovenia

CEE 4

Croatia

Baltics

SEE 2

2000-08

2009-12

Source: Eurostat; Commission services; CEE4 (CZ, HU, PL, 
SK); SEE 2 (BG, RO)

Graph 3.22: FDI inflows per sectors, % of total

40

30

20

10

0

1996-2008

2009-2013

Source: Commission services; HNB

Graph 3.23:Sectoral structure of inward FDI stock

100%

80%

60%

40%

20%

0%

HR

BG

HU

CZ

RO

SK

Other services
Financial activities
Transportation and storage
Construction
Utilities

Source: Eurostat

Real estate activities
Accommodation/food service
wholesale and retail trade
Manufacturing
Primary industries

is 

cases 

important 

in  2012 

insolvency 

of  pending  cases  by  20%  by  the  end  of  2012. 
Preliminary  data  indicate  that  the  number  of 
incoming 
rose 
significantly,  compared  to  2010.  Legal  certainty 
and  effective  processing 
for 
investment  and  adjustment.  This  is  the  case  not 
just  for  commercial  cases,  including  insolvency, 
but  also  labour  cases,  where  court  delays  and/or 
legal  uncertainty  can 
in 
stronger job protection de facto than de jure. These 
results  are  consistent  with  Croatia's  poor  score on 
the  resolving  insolvency  indicator  of  the  World 
Bank's  Doing  Business  Survey  2014,  which  finds 
procedures  take  3.1  years  to  conclude  (versus  1.7 
years  on  average  in  the  OECD)  and  that  the 
recovery  rate  is  around  30%  (vs.  70%  in  the 
OECD). 

theoretically 

result 

Structural  product  market  weaknesses  have 
also  been  present.  The  transport,  utilities  and 
postal  services  were  shielded  from  competitive 
pressures  during 
the  cyclical  upturn.  This 
protection  came  at  the  price  of  weaker  efficiency 
and  raised  costs  for  the  economy.  Increasing 
competition, in particular in electricity distribution, 
is  likely  to  lower  producer  costs  in  the  economy 
over the medium term.  

The role of FDI 

capital 

sizeable 

non-tradable 

sector,  with 

Croatia  has  missed  out  on  the  FDI  flows  that 
have  transformed  the  export  sectors  of  more 
in 
successful  peer  economies.  As  detailed 
Subsection  3.1.1., 
inflows 
comprising  a  high  share  of  FDI  led  to  the 
accumulation  of  a  significant  FDI  stock  in  the 
2000-2008 period. These inflows were comparable 
in  magnitude  to  those  of  regional  peers  (Graph 
3.21).  However,  the  bulk  of  FDI  was  directed  to 
the 
financial 
intermediation  and  real  estate  activities  and 
construction taking the lead. Countries such as the 
Czech Republic, Romania and Slovakia were able 
to  attract  a  greater  share  of  inward  FDI  into 
manufacturing  (see  Graph  3.22).  Inward-looking 
investments  in  telecommunication  and  retail  trade 
also featured prominently. Export-oriented sectors, 
on  the  other  hand,  attracted  a  small  share  of  the 
huge investment flows in the period, resulting in a 
structure 
markedly 
compared  to  some  of  the  CEE10  by  2012  (Graph 
3.23). 

sectoral  FDI 

different 

32 

 
 
 
 
 
 
Low FDI in export-oriented sectors reflects the 
full  range  of  cost  and  non-cost-competitiveness 
shortcomings  of  the  Croatian  economy.  In  the 
labour-intensive  export-oriented  sectors,  wage 
levels, taxation issues, labour regulatory issues and 
skills gaps are also likely to have deterred potential 
investors in the region. As a result of low FDI into 
export  industries,  Croatia  missed  opportunities  to 
integrate  into  global  supply  chains  and  did  not 
benefit  from  positive  technological,  governance 
and  financial  externalities  associated  with  export-
oriented 
to 
competitiveness  gains  and  support  economic 
growth. (21)   

ultimately 

lead 

FDI 

that 

FDI  flows  have  dried  up  with  the  economic 
crisis  and  the  remaining  trickle  still  does  not 
reach  export-oriented  sectors. Overall  FDI went 
down  sharply.  This  is  partly  a  result  of  weak 
investment  activity  in  Croatia's  traditional  EU 
investor  base. (22)  Competition  between  locations 
seeking  to  attract  FDI  has  also  intensified  in  the 
current low investment conjuncture. In this respect 
Croatia's  worsened  economic  prospects  and  slow 
progress  with  the  structural  reform  agenda  are 
major drawbacks. The real estate and construction 
sectors have continued to receive FDI as on-going 
projects  were  completed  and  foreign  retail  chains 
continued to expand on the Croatian market.  

Conclusion 

liabilities  coupled  with  major 
Substantial 
adjustment  challenges 
leave  Croatia  with 
external vulnerabilities. This section has detailed 
the  accumulation  of 
international 
investment position and gross external debt. While 
the current account has now closed, the adjustment 
process is set to be lengthy. A range of elements in 
the labour market, in the business environment and 

the  net 

and 

indirectly 

(21)  FDI  in  inward-facing  industries  can  also  contribute  to 
economy-wide  productivity 
support 
competitiveness  but  this  does  not  seem  to  have  been  the 
case  in  Croatia.  Notably,  FDI  in  the  financial  sector 
appears  to  have  led  to  banks  focusing  on  real  estate, 
construction  and  consumer  lending.  By  the  same  token, 
in  export-oriented  sectors  does  not  guarantee 
FDI 
successful  outcomes.  The  largest  FDI  transaction  in  the 
manufacturing  sector 
the 
purchase  of  a  stake  in  the  refinery  operator  which  is  now 
loss-making and subject to legal disputes. 

in  recent  years  concerned 

(22)  Outward FDI flows from the EU declined sharply after the 
global financial crisis and in 2012 recorded the lowest level 
since 2004. 

3. Imbalances and Risks 

in FDI trends have inhibited the growth and export 
performance that might speed the adjustment.  

of 

The Croatian manufacturing sector is in urgent 
need of renewal and FDI is the principal means 
by which this could be achieved. This section has 
highlighted  the  sharp  deterioration  in  Croatia's 
goods  exports  performance,  largely  due  to  the 
industries. 
near-collapse 
The 
certain 
manufacturing  sector  failed 
to  capitalise  on 
plentiful  FDI  in  the  boom  years.  The  economic 
crisis  and 
the  withdrawal  of  subsidies  have 
exposed  these  industries  as  uncompetitive  in  cost 
and non-cost terms. The sustainability and stability 
of  Croatia's  external  position  will  depend  on  the 
regeneration  of  a  manufacturing  sector  and  other 
complement 
potentially-exporting 
tourism  revenues.  Until  this  is  achieved,  Croatia 
with  its  high  foreign  liability  stock  will  remain 
vulnerable  to  currency  movements  and  shifts  in 
investor  sentiment.  An  FDI  facilitated  structural 
shift into tradable sectors and economic integration 
into the EU would represent a break with the past 
borrow-to-consume model and set the foundations 
for more sustainable growth. 

sectors 

to 

3.2. 

INDEBTEDNESS  AND  DELEVERAGING 
DYNAMICS 

investor 

Rapid credit expansion, strong domestic activity 
and 
optimism  were  mutually 
reinforcing  in  the  period  to  the  2008  crisis.  On 
the  supply  side,  credit  growth  was  funded  by 
sizeable  foreign  capital  flows,  driven  by  high 
global  liquidity  and  strong  investor  appetite  for 
emerging  markets  rather  than  by  country-specific 
factors.  These  flows  were  partly  channelled 
through the largely foreign-owned banking sector. 
Strong  economic  expansion  went  hand  in  hand 
with  a  steep  accumulation  of  debt  by  the  private 
sector, although from a relatively low level (Graph 
3.24). (23)  Both  households  and  non-financial 
corporations more than doubled their debt levels as 
a  share  of  GDP  in  the  period  2001-2008.  The 
towards  debt-financed 
significant 
investment  also  skewed  firms'  financing  choices, 

tax  bias 

(23)  The private sector in this analysis consists of non-financial 
corporations  and  household  and  non-profit  institutions 
serving  households.  Private  sector  debt  includes  securities 
other  than  shares  (excluding  financial  derivatives)  and 
loans. 

33 

 
                                                           
                                                           
3. Imbalances and Risks 

described  in  detail  in  Section  3.3.  Non-financial 
corporations  (NFC)  used  the  breathing  space 
afforded  by  these  policies  as  an  opportunity  to 
refinance  existing  liabilities,  including  external 
liabilities.  This  prevented  a  stronger  reduction  of 
the  debt  level,  but  did  not  stop  a  steep  decline  in 
new investment. Even so, negative feedback loops 
from  deleveraging  pressures,  economic  recession 
and  the  weak  fiscal  position  of  the  sovereign 
continue to weigh on the economy. The following 
subsections look at the drivers of indebtedness and 
the dynamics of deleveraging in the private sector 
(Subsection  3.2.2.)  and  public  sector  (Subsection 
3.2.3.) 
in  greater  detail.  Subsection  3.2.4. 
concludes  with  a  discussion  of  outstanding  policy 
challenges 
and 
to 
deleveraging. 

indebtedness 

related 

3.2.1.  Private sector indebtedness 

Strong  consumer  and  business  optimism, 
abundant  international  capital  flows  and  risk-
appetite  in  the  financial  sector  allowed  a  quick 
accumulation  of  debt  by  the  private  sector  in 
the  run-up  to  the  global  financial  crisis.  The 
Croatian  economy  was  not  alone  in  witnessing  a 
significant  increase  in  financial  liabilities  (Graph 
3.25),  but  its  debt  did  accumulate  rather  fast  in 
comparison, even taking into account the relatively 
limited  initial  levels  of  external  indebtedness. 
Growth 
that  of 
in  household  debt  outpaced 
corporate  debt,  partly  reflecting  a  lower  base,  but 
also loose lending policies on the part of banks. A 
widespread practice to extend credits linked to the 
Swiss  franc  to  unhedged  borrowers  generated  an 
exchange-rate 
a 
corresponding  credit  risk  for  banks  (see  also 
Section  3.3.). (25)  Rising  residential  prices  also 
contributed 
in  household 
indebtedness,  as  housing  loans  were  leveraged 
against  increasing  collateral  values.  Thus,  the 
household debt-to-GDP ratio peaked at 42% by the 
end  of  2010.  As  for  corporates,  a  gradual  rise  in 
indebtedness  culminated  with  a  steep  increase  at 
the  peak  of  the  business  cycle,  and  the  debt-to-

for  households 

increase 

risk 

and 

the 

to 

contributing  to  corporate  indebtedness. (24)  The 
state  was  able  to  reduce  its  outstanding  liabilities 
gradually  over  the  period  due  to  favourable 
economic  trends.  At  the  same  time,  however,  the 
state  accumulated  significant  contingent  liabilities 
as  it  granted  generous  government  guarantees  to 
state-owned  enterprises  (SOEs),  notably  those 
railway 
involved 
infrastructure and shipbuilding. 

in  highway 

construction, 

As  a  result,  Croatia  had  a  relatively  highly 
leveraged  private  sector  at  the  time  the  crisis 
started,  even  though  public  indebtedness  stood 
well below the EU average. With the onset of the 
crisis, the sudden halt in financial inflows, coupled 
with  a  rapid  contraction  in  external  and  domestic 
demand,  exposed  existing  vulnerabilities  in  the 
real  sector.  Prevailing  debt  stocks  also  hindered  a 
smooth  adjustment  in  the  financial  system  in 
response  to  the  deterioration  in  the  external 
environment. 

Graph 3.24: Debt by sector,  non-consolidated

200

150

100

50

0

P
D
G

f

o
%

01 02 03 04 05 06 07 08 09 10 11 40909

Financial corporations
Government
Households
Non-financial corporations
Non-financial private sector euro area
Non-financial private sector

Source: Eurostat

A  counter-cyclical  policy 
loosening  by  the 
monetary  authorities  allowed  buffers  in  the 
financial  system  to  absorb  the  shock  and 
accommodate  the  adjustment  of  the  Croatian 
economy  in  the  initial  phase  of  the  crisis.  The 
conduct  and  effectiveness  of  these  policies  is 

the 

subsequent 

(24)  This  bias  has  also  constrained  the  deleveraging  process 
during 
recession.  Debt-financed 
investments benefit from a negative effective marginal tax 
rate  which  is  among  the  highest  in  the  EU  (-18%  vs.  -5% 
on average for the EU), according to Commission services 
calculations.  The  high  debt  bias  of  corporate  taxation 
reflects generous depreciation allowances and treatment of 
financial costs. 

(25)  Swiss  franc-indexed  loans  accounted  for  over  a  third  of 
total  credit  growth  in  2005-2007.  They  were  mainly 
extended  to  households,  in  particular  for  house  purchases, 
while  the  corporate  sector’s  exposure  was  limited.  Even 
though these loans were largely suspended as of mid-2008, 
their  share  remained  relatively  high  at  10%  of  the  total 
outstanding credit at the end of 2013 from the 17.5% peak 
in early 2008. 

34 

 
 
 
 
                                                           
 
                                                           
 
3. Imbalances and Risks 

GDP ratio surged nearly 30 pp from 2007 to reach 
95%  in  2010,  supported  by  strong  borrowing  by 
both private and public companies. 

but 

loans), 

intra-company 

The  onset  of  the  crisis  did  not  bring  about 
immediate  deleveraging  pressures.  On 
the 
contrary,  debt  accumulation,  in  particular  by 
companies,  initially  continued  (see  Box  3.3  for  a 
sectoral  analysis  of  corporate  leverage).  This  was 
mostly  due  to  refinancing  provided  by  foreign 
parents  (reflected  in  a  growing  stock  of  cross-
border 
also 
accommodative  monetary  policies  that  ensured 
sufficient  domestic  liquidity.  With  the  nominal 
debt  level  increasing,  the  prolonged  economic 
contraction resulted in a further rise in the private 
sector debt-to-GDP ratio. Thus, it surged by 20 pp 
in only two years, peaking at 137% of GDP by the 
end of 2010, leaving the private sector amongst the 
most  indebted  in  comparison  to  regional  peers 
(Graph  3.25).  The  increase  was  almost  entirely 
accounted  for  by  the  corporate  sector,  while 
households  managed  to  keep  their  liability  level 
relatively  stable  despite  some  pressures  arising 
the  kuna-denominated 
from 
household debt as a result of the steep appreciation 
of  the  Swiss  franc  in  2010.  This  affected  loans 
(mainly  housing  and  car-purchase  credits)  linked 
to  the  Swiss  currency,  putting  a  strain  on  the 
household debt-service burden.  

increase 

the 

in 

Graph 3.25: Private sector debt

160

120

P
D
G

f

o
%

80

40

0

Euro
area

HR

HU

SI

PO

SK

CZ

Source: Eurostat

2001

2008

2012

In  view  of 
the  continuing  weakening  of 
economic  activity,  rising  unemployment,  and 
the  high  debt  levels,  deleveraging  pressures 
built  up  as  of  2011.  This  led  to  some  modest 

decrease  in  private  sector  leverage  as  net  credit 
flows to the domestic economy turned negative in 
2011.  Thus  the  total  private  sector  debt-to-GDP 
ratio fell by 5 pp since the peak at the end of 2010. 
Nearly  four-fifths  of  this  decrease  was  accounted 
for 
figures 
overestimate  the  actual  adjustment  due  to  the 
transfer  of  loans  to  shipyards  to  the  government 
accounts in 2012.  

companies, 

although 

the 

by 

turned  negative 

in  corporate  credit  exceeded 

Negative credit flows have driven deleveraging. 
Having  averaged  around  +15%  of  GDP  in  the 
period  2002-2008,  net  credit  flows  to  the  private 
in  2011  as  strong 
sector 
contraction 
the 
remaining flow of credit into the household sector. 
Credit  to  the  private  sector  fell  more  steeply  in 
2012-13.  Inflation  helped  to  curtail  the  private 
sector  debt-to-GDP  ratio  through  the  denominator 
(Graph 3.26 and Graph 3.27). Valuation changes in 
the form of debt write-offs also played a role in the 
corporate  sector,  although  their  contribution  was 
limited. 

Graph 3.26: Decomposition changes in debt-to-
GDP ratio, households

P
D
G
%

8

6

4

2

0

-2

-4

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Other changes in volume
Real GDP contribution
Total

Transactions, % GDP
Inflation contribution

Source: Commission servics calculations; Eurostat

35 

 
 
 
 
 
 
3. Imbalances and Risks 

the 

from 

The  household  sector  also  faces  deleveraging 
pressures.  These 
rapidly 
stem 
deteriorating  labour  market  and  falling  disposable 
income.  Negative  wealth  effects  as  a  result  of 
declining  residential  and  equity  prices  may  also 
play a role. (26) As a result, there has been a steep 
drop in the stock of some types of consumer credit 
(notably car loans and credit card lending). At the 
same time, the stock of outstanding housing loans, 
which  account  for  approximately  half  of  the  total 
household  debt,  remained  relatively  stable,  thus 
preventing  an  even  sharper  rebalancing  of  the 
households’  liability  position.  This  was,  however, 
largely due to the aforementioned negative foreign 
exchange 
the 
appreciation  of  the  Swiss  franc  (see  also  Section 
3.3). (27)  Vulnerabilities  nevertheless 
remain 
limited  due  to  the  still  relatively  low  level  of 
household debt compared to the EU average. 

rate  effects  associated  with 

(26)  In 2013, housing prices were down by 30% from their peak 
in  early  2008.  The  main  index  of  the  Zagreb  Stock 
Exchange,  Crobex,  lost  approximately  65%  of  its  value 
over the same period. 

(27)  Swiss  franc-indexed  housing  loans  reached  approximately 
40%  in  2008  and  their  share  in  the  housing  loan  stock 
remained stable for a long time because of the appreciation 
of the Swiss currency. 

Graph 3.27: Decomposition changes in debt-to-
GDP ratio, NFC

P
D
G
%

20

15

10

5

0

-5

-10

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Inflation contribution
Transactions, % GDP
Total

Real GDP contribution
other changes in trans.

Source: Commission services calculations; Eurostat

the 

subdued 

relatively 

The reduction in corporate sector indebtedness 
continues  at  a  slow  pace.  Debt  refinancing, 
reflecting ongoing support from parent companies, 
but also the tendency of banks to renew debts even 
to  risky  creditors  (bankruptcy  proceedings  and 
collection of debts are complex and costly), could 
explain 
of 
deleveraging in the corporate sector. On-going and 
elevated 
publicly-controlled 
companies also acted to moderate the overall pace 
of  adjustment  in  the  corporate  debt-to-GDP  ratio, 
as  did  the  weak  economic  performance  through 
falling  nominal  output  (other  than  in  2011). 
However,  when  measured  against  total  assets  (or 
equity), 
the  corporate  debt  ratio  kept  rising 
throughout  the  period,  thus  implying  growing 
financial risks (Graph 3.28). 

borrowing 

pace 

by 

Graph 3.28: NFC leverage indicators

120

100

80

60

40

20

0

%
s
t
e
s
s
a

d
n
a
P
D
G

,
y
t
i
u
q
e
o
t

t
b
e
d

f
o
s
o
i
t
a
R

01 02 03 04 05 06 07 08 09 10 11 12

Debt / equity

Debt / GDP

Debt / assets

Source: Eurostat

36 

 
 
 
 
 
 
 
 
 
 
 
 
 
                                                           
3. Imbalances and Risks 

Box 3.3: Financial Performance of Firms, including SOEs

High corporate debt levels, as described in this chapter, are concentrated in a few unprofitable sectors and in
firms  in  public  ownership. (1)  Graph  1a  shows  the  gross  amounts  of  debt  in  question,  by  sector,  to  help
interpret the magnitude of the issues raised by the ratios presented below.  

Graph 1:Indicators of financial strength

(a) Distribution of SOE debt

n
b
R
U
E

8

7

6

5

4

3

2

1

0

70%

60%

50%

40%

30%

20%

10%

0%

CONSTR UTIL

I&C

MAN

SERV TR&TR

Private

SOE

(c) Debt to invested capital

e
t
a
v
i
r

P

E
O
S

E
O
S

e
t
a
v
i
r

P

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

CONSTR UTIL

I&C

MAN

SERV TR&TR

Aggregate

Median

36.8
28.7

(b) Debt to EBITDA

25

20

15

%

10

5

0

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

E
O
S

e
t
a
v
i
r

P

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

CONSTR UTIL

I&C

MAN

SERV TR&TR

(d) Return on assets

15%

10%

5%

0%

-5%

-10%

-15%

E
O
S

e
t
a
v
i
r

P

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

e
t
a
v
i
r

P

E
O
S

CONSTR UTIL

I&C

MAN

SERV TR&TR

From  graph 1b,  one  can  determine  the  sectors  characterised  by  high  debt  relative  to  earnings  available  for
debt  servicing,  the  standard  debt  to  earnings  before  income  tax,  depreciation  and  amortisation  (EBITDA)
ratio. (2) The construction and real estate and the 'other services' categories exhibit high indebtedness overall
and SOEs are more indebted than non-SOEs within all categories except 'other services'. (3) Nearly a sixth of

(1)  The analysis is based on 2012 financial data for 8,545 Croatian companies obtained from the Bureau Van Dijk Orbis 
database,  of  which  104  are  (non-exhaustively)  identified  as  State-owned  enterprises  (majority  ownership  by  the 
central Government or local authorities). Privately-owned majority-controlled subsidiaries are included in the analysis 
due to identified data gaps at consolidated group level, which can lead to a small amount of double-counting (a check 
was also performed with data on a consolidated basis, which yields 3,913 firms, and the two approaches were found 
to yield broadly similar results). 

(2)  The debt/EBITDA ratio is used as a measure of solvency, where the denominator is a commonly used proxy of cash 

generating capacity (pre-tax). 

(3)  The high SOE reading for the construction sector stems from the three highway companies.

(Continued on the next page) 

37 

 
 
 
 
 
                                                           
 
 
3. Imbalances and Risks 

Box (continued) 

the  firms  analysed  recorded  negative  EBITDA  in  2012.  The  degree  and  extent  of  financial  weakness  is
consistent with the high and rising non-performing loan ratios of banks discussed in sub-section 3.3.  

Graph 1c shows the degree of reliance on debt within private firms' and SOEs' overall funding, confirming
the  high  indebtedness  of  construction  and  'other  services'.  (4)  The  upper  tail  of  the  firm  distribution  (not
graphed) is marked by very high leverage in most sectors and in particular for SOEs. Current indebtedness
problems are therefore not merely a result of depressed earnings, but also reflect somewhat debt-heavy capital
structures.  Within  the  private  sector,  the  information  and  communications,  manufacturing  and  trade  and
transport segments also appear to be somewhat highly leveraged. Debt restructuring may be needed in some
cases  to  make  these  financial  structures  more  efficient  (see  Box  3.4.  for  discussion  of  pre-insolvency
procedures). 

Graph 1c illustrates the low aggregate profitability of firms in several sectors, as proxied by return on assets.
SOEs  are  less  profitable  than  private  firms  on  aggregate  within  each  sector.  Within  information  and
communication, manufacturing, trade and transport, SOEs are, on aggregate, destroying value. (5) Returns at
the 50th and 75th percentiles show some private firms thriving, but not SOEs.  

These results help to contextualise the strategies of banks now focusing on SOE-lending (see Box 3.6. in sub-
section 3.3.), and provide circumstantial evidence that there are creditworthy private-sector firms that could
be disadvantaged by these trends. 

Graph 2b:Distribution of SOE employment

Graph 2a:Distribution of SOE debt

.
l
i

b
R
U
E

5

4

3

2

1

0

.
s
u
o
h
t

30

25

20

15

10

5

0

CONSTR UTIL

I&C

MAN

SERV

TR&TR

CONSTR UTIL

I&C

MAN

SERV

TR&TR

Debt/EBITDA < 9

Debt/EBITDA >= 9

Debt/EBITDA < 9

Debt/EBITDA >= 9

Graphs  2a  and  2b  show  the  policy  relevance  of  high  debt  levels  in  SOEs.  Taking  a  conservative  debt 
multiple of nine times EBITDA as a cut-off (6), the debt of over-indebted SOEs analysed here amounted to 
over seven billion euros at year-end 2012. These SOEs also employed 37,000 people. These figures provide 
a first-order quantification of the contingent fiscal liabilities arising from state ownership discussed in sub-
section 3.2. 

(4)  The share of debt in total capital employed (debt plus equity), reflecting a firm's financial leverage, is more revealing 
about funding choices (high amount of debt taken in the pre-crisis period) and abstracts from denominator effects (i.e. 
adverse shock to earnings during the crisis). 

(5)  The  causality  between  public  ownership  and poor  performance,  if  any,  may  run  in both  directions.  However,  SOE 

losses can generally be sustained longer. 

(6)  Even at 5x EBITDA a firm without demonstrable growth prospects might be considered over-indebted, but a higher 

threshold of 9x is used here to duly take into account low EBITDA in the 2012 recessionary context. 

38 

 
 
 
 
 
 
                                                           
 
 
 
reveals 

Cross-country 
that 
comparison 
Croatia's  private  sector  is  more  indebted  than 
those  of  other  countries  in  the  region.  Indeed, 
while during the boom years, households and firms 
in Croatia built up debt at comparable speed to the 
CEE10, the downturn in Croatia came later and the 
pace  of deleveraging was  slower (Graph 3.29  and 
Graph  3.30).  As  a  result,  by  the  end  of  2012 
Croatia's firms and households were more indebted 
than their peers in the CEE10 – by 6 pp points and 
7.1  pp  of  GDP  for  households  and  corporations, 
respectively.  This  could  impact  negatively  on 
and 
growth 
economic 
Croatia's 
competitiveness going forward. 

prospects 

Graph 3.29: Household leverage -
Croatia and CEE10

P
D
G

f

o
%

45

40

35

30

25

20

15

10

5

0

02 03 04 05 06 07 08 09 10 11 12

HR

CEE10 average

Source: Eurostat

Graph 3.30: NFC leverage - Croatia and CEE10

P
D
G

f
o
%

100

90

80

70

60

50

40

30

20

10

0

02 03 04 05 06 07 08 09 10 11 12

HR

CEE10 average

Source: Eurostat

Supply  constraints  have  contributed  to  the 
gradual  deleveraging of  the  economy as parent 
financing for the foreign-owned banking sector 

3. Imbalances and Risks 

to 

operations 

cross-border 

was  reduced.  This  process  was  particularly 
prominent  in  2012,  reflecting  a  shift  in  funding 
from 
domestic 
financing.  The  sharp  drop  in  banks’  foreign 
liabilities (almost one-fourth in the period from the 
peak  at  end-2011  to  August  2013)  highlights  the 
scale  of  reduction  of  external  funding  for  the 
financial  sector  which  was  partly  cushioned  by 
offsetting counter-cyclical measures on the part of 
the  monetary  authorities.  The  pace  of  bank 
deleveraging 
in  2013,  while 
increased  domestic  savings  also  compensated  for 
latter, 
the  shortage 
moreover,  contributes  to  mitigating  the  impact  of 
possible  capital  outflows,  e.g.  due  to  further 
potential  downscaling  of  financing  by  foreign 
banks  in  view  of  tighter  capital  regulations  and 
their on-going balance sheet adjustment.  

in  foreign  funding.  The 

largely  abated 

The  National  Bank  of  Croatia  (HNB)  has  been 
active  in  ensuring  sufficient  liquidity  in  the 
system  to  support  credit  flows. (28)  However, 
these  efforts  have  been  so  far  insufficient  to 
compensate  for  reduced  corporate  credit  demand 
due  to  the  recession.  Furthermore,  lenders  grew 
more  cautious  to  counter  the  worsening  of  their 
balance  sheets,  as  reflected  by  a  steep  increase  in 
the  share  of  NPLs. (29)  As  a  result  of  negative 
feedback  loops  from  rapidly  deteriorating  public 
debt  dynamics 
the 
domestic banks are becoming more closely linked 
with  the  sovereign:  since  2008,  the  larger  part  of 
the growing government financing needs has been 
raised  from  the  domestic  market.  This  could 
potentially  put  banks  at  risk  and  reduce  credit 
availability  for  the  private  sector  in  case  rising 
public  debt  is  not  put  back  to  a  sustainable 
path. (30) However, risks of a severe credit crunch 
appear  to  be  mitigated  by  the  still  strong,  well-
capitalised  and 
liquid  foreign-owned  banking 
system,  a  functional  capital  market,  and  the 

(see  Subsection  3.3.3.), 

(28)  In  an  attempt  to  increase  liquidity  and  spur  corporate 
lending, the National Bank of Croatia reduced commercial 
bank's  capital-reserve  and 
liquidity 
requirements  at  the  beginning  of 2009.  More  recently,  the 
central  bank  decided  to  cut  further  its  mandatory  reserve 
requirements  to  12%  from  13.5%,  effective  December 
2013. 

foreign-currency 

(29)  The  share  of  private  sector  NPLs  in  the  total  loan  book 
stood at close to 16% at the end of  2013, rising from  less 
than 5% at the end of 2008. 

(30)  Adverse  fiscal  trends  do  create  a  substantial  sovereign 
spread which is adding to the funding costs of the banking 
sector.  In  2013,  credit  default  swaps  started  to  diverge 
increasingly from those of comparable EU countries. 

39 

 
 
 
 
 
 
 
                                                           
3. Imbalances and Risks 

initial leverage. Nevertheless, a possible upturn in 
consumer  credit  will 
largely  depend  on  a 
turnaround  of  the  negative  trends  in  the  labour 
market and household income. Negative risks thus 
attach 
recession  depressing 
to  a  prolonged 
household spending power. 

3.2.2.  Public indebtedness 

The  ongoing  deleveraging  pressures  in  the 
private sector arise at a time of significant fiscal 
challenges  for  the  country.  To  the  extent  that 
deleveraging  trends  in  the  private  sector  are 
reflected 
investment  and  household 
consumption,  this  in  turn  depresses  revenues  and 
accentuates  the  consolidation  challenge  for  public 
finances, re-enforcing potential negative feedbacks 
to the real economy.  

in  weak 

Loose  fiscal  policy  during  the  cyclical  upturn 
limited  the  room  for  Croatia  to  respond  in  a 
counter-cyclical manner once the crisis started. 
The  prolonged  recession  has  caused  sustained  tax 
revenue losses that have only partially been offset 
by  numerous  indirect  tax  increases,  mostly  VAT 
and excises (Graph 3.32). Decisive reforms of the 
public  administration,  healthcare  and  pension 
systems  could  have  alleviated  pressures  arising 
from  the  expenditure side of  the budget, but  were 
delayed.  Sizeable  subsidy  payments  and  recurrent 
capital  injections  into  loss-making  state-owned 
enterprises  contributed  substantially  to  overall 
fiscal 
expenditure  pressures.  Moreover, 
position 
the 
increase in the budgetary interest burden following 
activation of state guarantees on loans extended to 
state-owned  enterprises 
the  now 
(mostly 
privatised shipbuilding sector). (31) 

further  deteriorated  because  of 

the 

in 

Croatia’s  general  government  deficit  averaged 
6.1%  of  GDP  in  the  period  2009-2013.  This 
figure,  which  reflects  the  negative  impact  on 
public 
is  not 
from 
finances 
significantly  different 
the  government 
deficits recorded in a number of CEE10 countries 

the 
from 

recession, 

(31)  The  stock  of  government  guarantees  to  public  companies, 
mainly  concerning  loss-making  entities  in  the  transport 
sector  and  the  shipbuilding  industry,  nearly  trebled  in  the 
period  2007-2011 to  above  14%  of  GDP.  As  a  result  of  a 
recent  restructuring  of  the  shipbuilding  industry,  in  line 
with the requirements for accession to the EU, the state had 
to assume their debs worth HRK 6.6 billion (2% of GDP) 
and ensure servicing of the credits that currently weighs on 
the expenditure side of the budget. 

commitment  of  foreign  parent  banks  under  the 
Vienna  Initiative  to  maintain  historic  liquidity 
levels in the region. 

Supply  factors  could 
lead  to  further  de-
leveraging  of  the  private  sector  as  banks  focus 
on lending to the government and SOEs. Indeed, 
a certain credit substitution of private sector loans 
with  credits  to  the  government  appears  to  have 
taken  place  since  the  end  of  2011.  In  particular, 
while  the  credit  to  the  government  has  increased 
by HRK 14 billion since 2011, the stock of credit 
institutions’  claims  on  the  non-financial  private 
sector  has  contracted  by  a  similar  amount  (see 
Graph  3.31).  However,  the  fall  in  private  sector 
credit  seems  to  be  largely  linked  to  declining 
demand by both households and corporations as a 
result of ongoing correction of their balance sheets 
and  very  weak  economic  activity.  It  was  also 
seriously  affected  by  one-off  factors  such  as 
corporate credit takeover by the state. 

Graph 3.31: Credit institutions' claims

n
o

i
l
l
i

b
K
R
H

140

120

100

80

60

40

20

0

25

20

15

10

5

0

-5

-10

-15

%

,
e
g
n
a
h
c

l

a
u
n
n
a

Government
Households
NFC (rhs)

NFC
Government (rhs)
Households (rhs)

Source: Commission services calculations based on HNB 

The  government  has  undertaken  measures  to 
strengthen pre-bankruptcy procedures (see Box 
3.4)  These  steps  could  facilitate  the  deleveraging 
process  in  the  economy,  in  particular  in  the 
corporate  sector.  At  the  same  time,  regulatory 
uncertainty,  including  on  taxation  and  on  the 
possible  development  of  a  system  of  energy 
certificates for certain residential sales, could lead 
to  lower  household  credit  demand  and  depressed 
activity. The household sector does appear to have 
maintained payment discipline and to be in a more 
favourable  position  to  withstand  deleveraging 
pressures in the medium term, also given its lower 

40 

 
 
 
 
 
                                                           
3. Imbalances and Risks 

Box 3.4: Pre-bankruptcy settlement legislation

The Financial Operations and Pre-Bankruptcy Settlement Act entered into force on 1 October 2012 with the 
objective  to  provide  a  solution  for  the  rapidly  mounting  indebtedness  in  the  crisis-stricken  economy  by 
finding  an  alternative  to  the  complex,  expensive  and  lengthy  bankruptcy  procedures  in  the  country.  The 
procedure  aims  at  facilitating  financial  restructuring  of  ailing  companies  but  also  gives  the  possibility  for 
settlement  for  individual  debtors  such  as  sole  proprietors  and  craftsman.  Apart  from  providing  a  viable 
solution  for  the  debtors,  it  is  also  considered  beneficial  for  creditors  in  view  of  simplified  procedures  for 
liability collection and higher return rates compared to the ones under the standard bankruptcy procedure.  

The results during the first year of the implementation of the measure have been encouraging although some 
loopholes in the legislation have become visible from its start. The pre-bankruptcy settlement not only put a 
break on liability accumulation, but managed to reduce the total stock of overdue payments by nearly HRK 
10  billion  in  the  period  to  HRK  34  billion  at  the  end  of  October (see  Graph  1).  The  number  of  insolvent 
companies (including sole proprietors and craftsmen) went down by 20% and some 15,000 job places had 
been retained, according to the calculations of the authorities. 

Despite  these  positive  developments,  a  number  of  shortcomings  remain.  The  role  of  the  state  is  not 
sufficiently  well  defined  as  it  participates  as  both  a  creditor  and  an  administrator  in  the  out-of-court 
settlement  process.  The  procedure  could  create  moral  hazard  incentives  by  either  making  unviable 
companies seek postponement of the standard bankruptcy procedure (in an attempt to avoid the exercise of 
the right of foreclosure by creditors) or by encouraging healthy companies to pursue debt haircuts. The latter 
possibility could be suggested by the amount of company claims for restructuring – nearly  HRK  53bn, or 
16% of GDP, in slightly more than a year. Issues with efficient implementation of the legislation arise from 
the  still  weak  institutional  capacity  of  the  country,  but  also  various  loopholes  in  the  legal  definitions  that 
necessitated four legislative changes in a year. 

Graph 1:Overdue liabilities of insolvent companies

n
b
K
R
H

45

40

35

30

25

20

15

10

5

0

20

16

12

8

4

0

P
D
G

f
o
%

Overdue claims, HRK bn

Overdue claims, % of GDP

Source: Commission services; Economic Chamber of Croatia 

(Graph 3.33), but gives rise to greater concerns due 
to  the  relatively  higher  debt  level  and  Croatia's 
lower 
The 
prospects. 
growth 
Commission Winter 2014 forecast shows an  

near-term 

improvement in Croatia's budget deficit in 2014-15 
mainly  as  a  result  of  the  one-off  effect  of 
transferring  a  part  of  the  assets  from  the  second 
pillar  private  pension  system  to  the  first  –  state  -
pillar.  Under  the  ESA95  accounting  rules,  which 
will  be  replaced  in  September  2014 by  ESA2010, 
the  headline  general  government  deficit  would 
improve  to  5.4%  and  4.7%  of  GDP  in  2014  and 

41 

 
 
 
 
 
 
 
 
 
 
3. Imbalances and Risks 

Graph 3.33: General government balance

P
D
G

f
o
%

2

0

-2

-4

-6

-8

PL EE LV BG LT RO CZ HU SK SI HR

2009-13

2014-15

2009-13, CEE10 av.

2014-2015, CEE10 av.

Source: Commission services Winter 2014 forecast; Eurostat

Graph 3.34: General  government 
structural balance

P
D
G

f

o
%

0

-1

-2

-3

-4

-5

-6

-7

EE BG RO LV LT SI HU SK CZ PL HR

2009-2013

2014-2015

2009-13, CEE10 av.

2014-15, CEE10 av.

Source: Commission services Winter 2014 forecast; Eurostat

Graph 3.35: General government debt

P
D
G

f
o
%

90

80

70

60

50

40

30

20

10

0

EE BG HU PO CZ LV LT RO SK HR SI

2007-08 low 2013

change (rhs)

Source: Commission services calculations; Eurostat

2015,  respectively.  Abstracting  from  this,  there 
would  be  a  marked  deviation  in  the  medium-term 
fiscal trends of Croatia. Croatia’s structural budget 
deficit is projected at 5.3% of GDP on average in 
the  period  2014-2015  compared  with  only  2.2% 
for the CEE10 (see Graph 3.34). 

Graph 3.32: Consolidated central government

i

e
g
a
r
e
v
a
g
n
v
o
m
h
t
n
o
m
-
2
1

,
n
b
K
R
H

12

11

10

9

8

7

Revenues

Expenditures

Source: Ministry of Finance; Commissioon services calculations

since 

Persistent  primary  budget  deficits,  rapidly 
growing  interest  expenditures  and  negative 
stock-flow adjustments have resulted in a sharp 
deterioration  of  Croatia’s  general  government 
the  crisis. These  developments, 
debt 
combined with  nominal  GDP  remaining below  its 
2008  peak  for  a 
the 
government  debt-to-GDP  ratio  by  nearly  30  pp  in 
four years to estimated 64.9% of GDP at the end of 
2013  (Graph  3.35). (32)  Although  this  ratio  still 
remains  well  below  the  EU  average,  it  is  among 
the  highest  among  the  CEE  Member  States  and 
remains subject to numerous sustainability risks. 

long  period,  boosted 

(32)  See European Commission (2014) 

42 

 
 
 
 
 
 
                                                           
 
 
 
 
 
 
 
 
 
 
also  has 

implications 

The  relatively  short  maturity  structure  of 
public  debt 
for 
sustainability  and  debt  management.  It  exposes 
the  country  to  vulnerabilities  stemming  from  a 
possible  worsening  of  financing  conditions  on 
global  markets  that  would  further  increase  the 
already  high  borrowing  costs.  The  sovereign 
financing  needs,  consisting  of  debt  (including 
short-term  debt) 
the  net 
lending/borrowing  by  the  state,  will  continue  to 
grow,  reaching  close  to  20%  of  GDP  in  2014. 
While 
instruments 
including 
denominated in foreign currency, are concentrated 
in the first few months of the year, the government 
is already largely pre-funded for 2014. 

refinancing 

rollovers, 

and 

of 

Weak state-owned companies continue to cloud 
the prospects for public finances. Their liabilities 
have  occasionally  migrated  into  the  government's 
balance  sheet  and  thus  served  as  an  important 
factor  for  the  growing  deficit  and  debt  figures  in 
recent  years.  In  the  absence  of  more  ambitious 
restructuring  efforts  in  the  railway  and  road 
infrastructure  companies,  the  main  recipients  of 
state guarantees, the risk of additional debt pile-up 
for the state remain significant. 

Graph 3.36: Contingent state liabilities

20

15

10

5

0

P
D
G

f

o
%

State guarantees

Debt of Croatian Development Bank

Source: Ministry of Finance

A  high  foreign  exchange  share  of  the  public 
debt  exposes  Croatia  to  potential  currency 
shifts. (33) A number of empirical studies highlight 
unfavourable  exchange  rate  shocks  as  a  source  of 
risk  for  Croatia’s  debt  sustainability. (34)  These 

(33)  Approximately  75%  of  Croatia’s  government  debt  was  in 

foreign currency at the end of 2013. 

(34)  See Sopek (2011) and National Bank of Croatia (2013). 

3. Imbalances and Risks 

risks  should  be  viewed  against  the  good  track 
record  of  the  central  bank  of  ensuring  stability  of 
the local currency against the euro, a policy made 
necessary by the high euroisation of the economy. 
International  reserves,  coupled  with  considerable 
forex  proceeds  from  the  tourist  sector,  further 
contributes to the stability of the local currency. 

Several  factors  mitigate  public  finance  risks. 
Croatia  benefits  from  a  relatively  deep  financial 
market  that  for  the  time  being  has  been  able  to 
meet the financing needs of the state at a relatively 
low price. This refers to both short-term financing 
needs  (covered  mostly  by  commercial  banks)  and 
long-term  ones  (institutional  investors,  namely 
pension  funds).  High  liquidity  in  the  banking 
system,  supported  by  expansionary  central  bank 
policies,  coinciding  with  a  period  of  weak  credit 
demand  from  the  real  sector,  have  made  lenders 
focus  on  financing 
thus  bringing 
domestic  borrowing  costs  for  the  sovereign  to 
(Graph  3.37). 
record 
low 
Furthermore,  despite 
the 
country  successfully  tapped  international  markets 
in  November  2013.  However,  it  should  be  noted 
that  growing  external  debt  service  costs  are 
exerting  significant  pressures  on 
the  budget, 
narrowing  the  possibility  for  growth-enhancing 
spending  in  a  situation  of  weak  revenue  proceeds 
and insufficient expenditure-side reforms. 

in  2013 
rating  downgrades, 

the  state, 

levels 

Graph 3.37: T-bills auctions, average yields

8%

7%

6%

5%

4%

3%

2%

1%

0%

Jan-05

Jun-06

Mar-08

Sep-09

Sep-11

Jun-13

3-month

6-month

1-year

Source: Ministry of Finance of Croatia

43 

 
 
 
 
                                                           
 
 
                                                                                   
 
 
3. Imbalances and Risks 

44 

 
 
3. Imbalances and Risks 

Box 3.5: Public debt sustainability analysis

This box provides an assessment of the sustainability of Croatia's public debt using the Debt Sustainability 
Monitor  (DSM)  model  developed  by  the  Commission’s  services.  The  debt  simulations (1),  which  take  as 
point  of  departure  the    Commission  Winter  2014  forecast,  are  based  on  a  no-policy  change  assumption, 
which  means  that  no  fiscal  consolidation  measures  are  considered  in  addition  to  the  ones  included  in  the 
forecast. (2) 

Under the baseline scenario, Croatia’s public debt is projected to further increase and reach 83% of GDP at 
the end of 2020 (Graph 1a). The debt-to-GDP ratio exceeds 90% at the end of 2020 in two negative-shock 
scenarios  incorporated  in  the  model.  When  stressing  for  the  exchange  rate  dynamics,  assuming  a  10% 
permanent depreciation of the local currency against the euro(3), and a lower-than-expected GDP growth (4), 
public  debt  is  estimated  to  reach  96%  of  GDP.  This  reflects  mostly  the  high  share  of  foreign  currency-
denominated  debt,  which  was  above  70%  of  the  total  at  the  end  of  2013.  A  largely  similar  negative  debt 
trajectory  is  recorded  when  testing  for  unfavourable  GDP  dynamics  and  sensitivity  on  interest  rates,  to 
reflect possible heightened tensions on financial markets that could lead to an increase of financing costs. (5) 

Graph 1a: General government gross debt

100

90

P
D
G

f
o
%

80

70

60

50

13

14

15

16

17

18

19

20

Baseline senario (Winter 2014 ECFIN forecasts)
One-off exchange rate depreciation and lower growth
Higher interest rate and lower growth
Lower interest rate and higher growth
Institutional (SGP) scenario

0.1

0.09

0.08

0.07

0.06

0.05

0.04

0.03

0.02

0.01

0

Graph 1b: 3-year average level of structural 
primary balance (1998-2012) - probability 
distribution

Less

-3.5

-2

-0.5

1

2.5

4

5.5 More

AVG 03-12 SPB for HR: percentile rank of 81%

2015 SPB for HR: percentile rank of 59%

Source: Commission services

Source: Commission services

A positive-shock scenario has been also simulated to reflect possible improvements in the economic context, 
partly  stemming  from  the  potential  favourable  impact  for  the  economy  from  the  absorption  of  EU  funds. 
These positive effects would be translated in both higher growth and lower interest rates on new and rolled-
over  debt.  In  this  case,  GDP  growth  is  revised  upwards  relatively  to  the  baseline  scenario,  while  interest 
rates on new and rolled-over debt are lowered. (6) Under this scenario, general government debt would still 

(1)  In the model, the short- and long-term interest rates have been adjusted to be consistent with forecast implicit interest 
rates, the latest Eurostat data on the shares of short- and long-term public debt, and Bloomberg data on maturing debt. 
(2)  This  means  that  the  structural  primary  deficit  projection  of  1.1%  of  GDP  for  2015  is  kept  constant  at  that  level 
thereafter.  The  long-term  budgetary  projections  for  GDP  growth  and  changes  in  age-related  public  expenditures, 
namely for pensions and health care, are those calculated by the Croatian Central Bureau for Statistics and reported in 
Croatia’s 2012 pre-accession economic programme. 

(3)  Such an assumption seems on the conservative side in historical perspective. 
(4)  Compared to the baseline, GDP growth is assumed to be lower by -1.5 pp in 2014 and 2015 and -1 pp afterwards. 
(5)  This model assumes a permanent increase of by 50 bp in short- and long-term interest rates on new and rolled-over 
debt  from  2014,  accompanied  by  a  decrease  of  GDP  compared  to  the  baseline  (-1.5  pp  in  2014  and  2015,  -1  pp 
afterwards) 

(6)  Growth is assumed to be high than the baseline by 0.5 pp in 2014, 1 pp in 2015, and 1 pp afterwards, while interest 
are lower by 1 pp from 2014 onwards. This would translate in an average real GDP growth of about 2.7% over the 
period 2014-2020 (1.7 pp higher than in the baseline) and an implicit interest rate of 5.6% in 2020 (0.7 pp lower). 

(Continued on the next page) 

45 

 
 
 
 
 
 
                                                           
 
 
 
3. Imbalances and Risks 

Box (continued) 

continue rising (given the primary  deficit  forecasted  for 2015),  reaching about 72% of  GDP at the end of 
2020, although the pace of its increase would slow down considerably. 

This  reveals  that  a  debt  reduction  path  can  be  achieved  only  by  having  further  fiscal  consolidation. 
Moreover, historical outcomes for the Croatian structural primary balance did not appear to be sufficiently 
ambitious, ranking only in the 81th percentile compared with EU countries (see Graph 1b above). (7) This 
low rank largely reflects the past low debt ratio in Croatia, allowing for a relatively lax structural primary 
balance.  Furthermore,  reaching  and  sustaining  a  structural  primary  deficit  of  -1.1%  of  GDP  would  not 
appear to be too demanding in relation to past outturns, as it corresponds only to the 59th percentile of the 
distribution, suggesting that there is some margin for taking additional consolidation measures. 

Therefore,  a  fifth  scenario  has  been  considered,  an  'institutional'  one,  where  adjustments  to  the  structural 
primary balance are set in compliance with the fiscal effort recommended under the EDP (an improvement 
in the structural primary balance of 1.8 pp, 0.9 pp and 0.3 pp of GDP between 2014 and 2016, respectively) 
until  the  excessive  deficit  is  corrected.  Thereafter,  additional  structural  (de)consolidation  effort  is 
implemented until the medium-term objective (MTO) is reached and maintained. (8) A feedback effect of the 
fiscal consolidation on GDP growth has been applied in proportion to the difference between the forecasted 
fiscal effort (change in the structural balance) and the assumed fiscal effort. Graph 1a shows that adhering to 
these fiscal rules would be sufficient to stabilise the debt to GDP ratio at about 62% of GDP by 2020. (9) 

In  conclusion,  the  debt  sustainability  analysis  shows  that  the  debt-to-GDP  ratio  can  be  stabilised  only  if 
substantial  fiscal  adjustment  is  achieved  and  maintained  -  meaning  correction  of  the  excessive  deficit  by 
2016 and thereafter benchmarking fiscal adjustment towards the MTO. This would entail an improvement 
from a structural deficit of 5.6% of GDP in 2014 to the MTO of -1.5% of GDP in 2017. 

(7)  The  rank  is  an  indication  as  to  where  the  country  specific  fiscal  effort  observed  or  projected  lies  in  the  overall 

distribution of fiscal efforts made by all EU countries over the years 1998 to 2012. 

(8)  An indicative MTO of -1.5% of GDP has been calculated for Croatia. 
(9)  A 1 p.p.-of-GDP consolidation effort impacts negatively on baseline GDP growth by 0.5 pp in the same year. In the 
IMF  October  2010  World  Economic  Outlook  (Chapter  3)  it  is  found  that  a  fiscal  consolidation  of  1%  of  GDP 
typically reduces GDP growth by 0.5% within 2 years. This result is based on fiscal actions to reduce the deficit in 15 
advanced  economies  (Australia,  Belgium,  Canada,  Denmark,  Finland,  France,  Germany,  Ireland,  Italy,  Japan, 
Portugal, Spain, Sweden, UK, US) over 1980-2009.

The  state's  asset  management  activities  also 
affect  the  debt  and  fiscal  risks.  The  banks  were 
successfully  privatised  before  the  crisis,  which 
brought revenues and increased the stability of the 
sector (see Section 3.3.). The privatisation process 
has  continued  at  a  slow  pace,  but  there  has  been 
limited  investor  appetite  for  the  state's  remaining 
assets  since  the  crisis  and  the  government  did not 
achieve  its  targeted  sell-off  revenues  in  2013.  If 
the  planned  sale  of  the  biggest  insurer  and  the 
possible  concession  to  run  the  highways  were 
transacted,  this  would  lead  to  a  significant  rise  in 
proceeds  in  2014  and  thus  have  a  positive  impact 
on  the  public  debt  dynamics.  The  restructuring  of 
troubled  state-owned  companies  could  also  have 
an indirect positive impact by reducing contingent 
future  government 
liabilities 
expenditures  (in  the  forms  of  subsidies  or  re-
capitalisation  costs).  The  weight  of  contingent 

and  possible 

46 

already  declined  with 

liabilities  has 
the 
restructuring  of  the  shipbuilding  sector  and  could 
further  diminish  if  re-organisation  in  the  railway 
sector is stepped up. 

3.3.  MONETARY  AND  FINANCIAL  SECTOR 

ISSUES 

Croatia is experiencing the after effects of a period 
of  rapid  credit  growth,  driven  by  internal  and 
external financial institutions. While the authorities 
used  macro-prudential  measures  to  limit  lending 
from domestically-supervised banks,  indebtedness 
still  grew  very  rapidly  due  to  both  external 
borrowing  (directly  from  the  foreign parent  banks 
of Croatian subsidiaries) and borrowing from non-
bank 
the 
deterioration  in  the  financial  position  of  the 

intermediaries.  With 

financial 

 
 
                                                           
 
 
 
corporate  sector,  banks'  non-performing  loans 
(NPLs)  to  corporate  borrowers  have  reached  high 
levels. Still, the conservative approach adopted by 
the  Croatian  National  Bank  (HNB)  to  macro-
prudential regulation, notably in relation to capital 
levels, has meant that banks have built up a degree 
of resilience that has proven to be useful given the 
challenges they now face from the weak economy.  

In order to assess the extent to which the financial 
sector can contribute to imbalances and risks, this 
section  begins  with  a  brief  review  of  macro-
prudential  policy  in  the  run-up  to  the  crisis.  It 
continues  with  an  overview  of  monetary  and 
exchange 
the 
situation of the banking sector. 

rate  policy,  before  analysing 

3.3.1.  Macro-prudential  policy  in  Croatia  in 

the run-up to the crisis 

and  monetary/exchange-rate 
Macro-prudential 
policies  have  been  closely  interlinked  in  Croatia. 
The  authorities  sought  to  internalise  the  potential 
risks to financial stability associated with being an 
economy  subject  to  volatile  capital  flows  and 
exhibiting  a  high  degree  of  euroisation.  In  an 
environment  of  rapid  financial  liberalisation  and 
with  insufficient  support  from  fiscal  policies,  the 
HNB relied on macro-prudential measures to limit 
balance sheet risks for banks, slow down the pace 
of  credit  growth  and  increase  the  banking  sector's 
resilience  against  the  vulnerabilities  of  financial 
euroisation.  

Managing balance sheet risk 

Limits  on  banks'  net  open  foreign  exchange 
positions sought to avoid currency mismatches on 
banks'  balance  sheets.  Raising  or  lowering  the 
limit allowed the HNB to affect credit conditions. 
The  limit  was  initially  set  at  20%  of  regulatory 
capital,  but  was  raised  to  30%  during  the  crisis, 
mainly to allow banks to take on foreign currency 
loans  or  deposits  without  having  to  increase  their 
assets. 

The authorities sought to take into account indirect 
credit  risk  for  banks  stemming  from  currency 
mismatches  on  borrowers'  balance  sheets.  From 
2004,  the  HNB  tightened  capital  requirements  for 
lending  in  foreign  currency  through  higher  risk 
weights  on  loans  denominated  in  or  indexed  to 
foreign  currency.  From  mid-2006,  an  additional 

3. Imbalances and Risks 

25%  risk  weight  add-on  had  to  be  applied  for 
foreign currency loans to unhedged borrowers, and 
at the beginning of 2008, the add-on was raised to 
50%.  The  measures  had  to  be  abolished  at  the 
beginning of 2010, as the implementation of Basel 
II  no  longer  allowed  for  higher  risk  weights  for 
foreign  currency  loans.  The  HNB  responded  by 
raising  the  required  minimum  capital  ratio  from 
10%  to  12%.  Under  Basel  III,  the  HNB  now 
explicitly accounts for currency-induced credit risk 
in its supervisory review process (pillar 2). 

Measures 
increase reserve buffers 

to  contain  credit  growth  and 

Measures were put in place to slow down the pace 
to  be 
of  credit  growth.  The  first  measure 
implemented was the 'credit growth reserve' (2003 
to  early-2004),  which  required  banks  to  purchase 
low-yielding  central  bank  bills  in  the  event  of  a 
more  than  4%  expansion  of  credit  in  a  given 
quarter.  The  measure  was  partly  effective  in 
containing  lending  growth,  but  it  also  produced 
evasion  effects  as  lending  activity  was  shifted  to 
leasing  companies  or  replaced  by  direct  cross-
border lending by parent banks. In addition, it may 
have distorted competition by discouraging smaller 
banks  from  expanding  more  rapidly  and  gaining 
market share.  

reserve 

'marginal 

Some  of  the  negative  side  effects  of  macro-
prudential  measures  were  addressed.  From  mid-
2004, the 'credit growth reserve' was replaced by a 
measure targeting banks' external funding sources. 
The  so-called 
requirement' 
obliged banks to deposit between 24% (2004) and 
55%  (from  late  2005)  of  their  newly  incurred 
foreign  liabilities  in  non-interest  bearing  accounts 
with  the  central  bank. (35)  From  early  2006,  the 
marginal  reserve  requirement  was  complemented 
by a 'special reserve requirement' to be applied on 
banks'  liabilities  from  newly  issued  securities. 
Both  measures  were  removed  following  the  onset 
of the crisis in October 2008 to allow parent banks 
to  support  their  subsidiaries.  Between  2007  and 
2009,  a  revamped  version  of  the  credit  growth 
reserve  was  put  in  place,  this  time  covering  a 

(35)  This  increase  in  the  regulatory  cost  of  foreign  borrowing 
encouraged parent banks to boost the capital ratios of their 
subsidiaries rather than extend loans, partly explaining the 
high capital ratios of Croatian subsidiaries. 

47 

 
                                                           
3. Imbalances and Risks 

broader  set  of  assets  and  reducing  the  lending 
growth ceiling to 1% per month. 

Reserve  requirements  on  deposits  were  also  used.  
These  ranged  from  17%  to  19%  in  the  pre-crisis 
period. From December 2008, the HNB cut reserve 
requirements  in  various  steps  to  stimulate  lending 
and  assist  government  programmes  for  providing 
cheap  loans  to  the  corporate  sector.  In  December 
2013, the reserve requirement stood at 12%. 

Liquidity management 

their  own 

foreign  exchange 

As  the  HNB  faced  constraints  in  fulfilling  its 
function  of  lender  of  last  resort  to  the  heavily 
euroised  banking  system,  banks  were  required  to 
liquidity 
build 
reserves.  In  2003  a  'foreign  currency  liquidity 
requirement'  was 
that 
banks  hold  35%  of  their  total  foreign  currency 
liabilities (including deposits) in liquid assets with 
a maturity of no more than three months. The rate 
was  lowered  in  several  steps  in  the  course  of  the 
crisis to reach 17% in 2013. 

introduced,  prescribing 

Assessment and challenges 

The  macro-prudential  policies  ensured  that  banks 
built  up  capital  and  liquidity  buffers,  which  were 
both  useful  during  the  crisis.  In  particular,  the 
marginal  and  special  reserve  requirement  and  the 
higher  risk  weights  applied  to  foreign  currency-
loans  to  unhedged  borrowers  helped  to  build 
significant  loss-absorbing  capacity,  with  capital 
adequacy ratios of about 20% for the largest banks. 
The banking sector was also well prepared to cope 
with  the  almost  complete  cessation  of  foreign 
inflows  in  late  2008/early  2009,  thanks  to  high 
foreign currency liquidity buffers in the system.  

As the experience of other countries demonstrates, 
even well-designed macro-prudential measures can 
give rise to substantial "leakages", and may not be 
fully  effective  in  containing  credit  growth. (36)  In 
the  presence  of  credit  growth  limits,  foreign-
owned  subsidiaries  helped  arrange  cross-border 
borrowing  from  parent  banks  and  set  up  leasing 

(36)  For example, Aiyar, Calomiris and Wieladek (2012) found 
that  macro-prudential  measures  in  the  UK  were  not  fully 
successful  in  constraining  aggregate  credit  growth.  While 
regulated banks reduced their lending in response to tighter 
capital  requirements,  this  was  partly  offset  by  increased 
lending by unregulated banks. 

48 

the 

also 

currency 

attempted 

sheets.  Banks 
foreign 

companies  to  shift  part  of  the  lending  activity  off 
balance 
to 
circumvent 
liquidity 
requirement  by  offering  kuna  deposits  indexed  to 
an  exchange  rate.  While  leasing  companies  were 
brought  under  the  supervision  of  the  non-bank 
regulatory  agency  HANFA  and 
foreign 
currency  liquidity  requirement  was  extended  to 
cover  currency-indexed  deposits  from  2006,  the 
HNB's  ability  to  reign  in  cross-border  lending 
remained limited.  

the 

While  the  banking  sector  is  largely  shielded  from 
direct  exchange  rate  risk,  it  is  still  exposed  to 
foreign-currency-linked credit risk. The practice of 
extending  loans  either  denominated  or  indexed  in 
foreign currency transferred the exchange rate risk 
to  banks'  clients,  large  parts  of  which  were 
unhedged, even though export-oriented companies 
and  about  10%  of  households  have  access  to 
foreign  income  (remittances,  tourism).  In  the 
dominant euro-denominated loan segment, the risk 
is  limited  by  the  authorities'  commitment  to  a 
broadly  stable  HRK/EUR  exchange  rate.  In  the 
Swiss  franc-denominated  loan  portfolio,  however, 
credit  risk  started  to  materialise  in  the  form  of 
rising  NPLs,  following  the  appreciation  of  the 
Swiss  franc  against  the  kuna  in  autumn  2011. 
Meanwhile, NPLs for household loans remain well 
below those for corporate loans. 

3.3.2.  Monetary and exchange rate issues 

Maintaining  a  broadly  stable  exchange  rate  of 
the  kuna  against  the  euro  has  been  a  key 
element  of  Croatia's  economic  policy  strategy. 
The  exchange  rate  as  a  nominal  anchor 
is 
considered important for two main reasons. First, it 
serves as a key anchor for price stability given the 
country's  high  import-dependency.  Second,  it  is 
important from a financial stability perspective due 
to  the  high  foreign  currency  exposure  of  both  the 
public  and  the  private  sector.  The  degree  of 
financial  euroisation  in  Croatia  is  among  the 
highest  in  the  world,  which  stems  from  a  strong 
preference  of  the  population  for  saving  in  foreign 
currency, combined with an obligation on banks to 
adjust 
the  currency  structure  of  assets  and 
liabilities. (37) While the kuna is the currency used 

(37)  Tkalec and Verbic (2012) found that negative balance sheet 
effects  following  a  depreciation  of  the  kuna  against  the 
on 
euro  would 

outweigh 

positive 

effects 

any 

 
                                                           
                                                           
3. Imbalances and Risks 

for  payments,  the  vast  majority  of  savings  and 
loans are either denominated in or linked to foreign 
currency  (71%  of  loans  and  83%  of  deposits). 
Apart from the euro (61% of outstanding loans and 
almost  all  foreign  currency  deposits),  the  Swiss 
franc  plays  a  role,  though  its  importance  has 
gradually decreased since the crisis (to about 10% 
of outstanding loans). 

The exchange rate regime can be described as a 
tightly  managed  float.  Over  the  past  decade,  the 
HRK/EUR  exchange  rate  has  remained  broadly 
stable,  with  movements  between  7.1  and  7.7 
(Graph  3.38).  The  central  bank  does  not  defend  a 
pre-determined  target  rate  or  band,  but  aims  at 
countering  excess  volatility. 
It  uses  macro-
prudential  tools  and  occasionally  intervenes  on 
currency markets. Foreign exchange reserves stood 
at EUR 12.9 billion at year-end 2013, equivalent to 
around 29% of GDP and covering close to 90% of 
short-term  external  debt.  Although  the  pace  of 
reserve  growth  has  slowed  down  following  the 
outbreak  of  the  financial  crisis,  Croatia  continues 
to accumulate foreign currency reserves. However, 
this  also  reflects  borrowing  on  external  markets, 
notably  by  the  government,  which  brings  its  own 
vulnerabilities. 

Graph 3.38: Kuna exchange rate

10

9

8

7

6

5

4

3

2
0
/
1
/
1

2
0
/
7
/
2
1

3
0
/
1
/
0
2

3
0
/
7
/
1
3

4
0
/
2
/
8

4
0
/
8
/
8
1

5
0
/
2
/
6
2

5
0
/
9
/
6

6
0
/
3
/
7
1

6
0
/
9
/
5
2

7
0
/
4
/
5

8
0
/
4
/
3
2

8
0
/
1
1
/
1

9
0
/
5
/
2
1

7
0
/
0
1
/
4
1

0
1
/
5
/
1
3

0
1
/
2
1
/
9

1
1
/
6
/
9
1

9
0
/
1
1
/
0
2

1
1
/
2
1
/
8
2

2
1
/
7
/
7

3
1
/
1
/
5
1

3
1
/
7
/
6
2

EUR/HRK

USD/HRK

CHF/HRK

Source: HNB

In  nominal  and  real  effective  terms,  the  kuna 
remained  broadly  stable  during  2013.  While  it 
appreciated by 1½% in nominal effective terms, it 
remained almost unchanged in real effective terms 

competitiveness.  The  latter  would  arguably  be  limited  by 
the narrow export base and large import content of exports. 

(Graph  3.39).  A  slight  nominal  depreciation 
against  the  euro  was  counterbalanced  by  an 
appreciation  against  the  US  dollar,  the  Chinese 
yuan  and  the  Russian  ruble  –  the  currencies  of 
Croatia's  most  important  non-euro  area  trading 
partners. In real-effective terms (CPI-deflated), the 
kuna  has  benefited  from  slightly  lower  inflation 
compared  to  trading  partners  since  mid-2010, 
which  resulted  in  a  slightly  lower  real-effective 
exchange  rate  path  as  compared  to  the  nominal-
effective rate.  

inflation  has  been  very  sensitive 

In  contrast  to  many  other  countries  in  the 
region,  Croatia  experienced  relatively  low  and 
broadly stable inflation during the past decade. 
While 
to 
commodity  price  shocks  (food  prices  in  2007-8, 
energy  prices  in  2012),  the  responsiveness  to  the 
business  cycle  has  been  more  muted,  both  during 
the  boom  period  and  during  the  crisis.  Annual 
inflation  was  2.8%  on  average  during  the  past 
decade, the third lowest among the CEE and Baltic 
countries.  Since  the  onset  of  the  crisis  in  2009, 
annual  inflation  has  come  down  to  2.2%  on 
average. 

Graph 3.39: Croatia - Real and nominal effective 
exchange rates
(42 countries; monthly data)

115

110

105

100

0
0
1
=
3
0
0
2

,
x
e
d
n

I

95

90

3

2

1

0

-1

-2

e
g
n
a
h
c
%
m
-
o
-
m

1/1/03

1/1/05

1/1/07

1/1/09

1/1/11

1/1/13

Weighted HICP/CPI deflator  RHS
REER (CPI-deflated) LHS
NEER LHS
Source: Commission services 

The low inflation environment allowed the HNB 
to maintain an accommodative monetary policy 
stance,  with  continued  high  liquidity  provision 
to  the  banking  sector.  Between  December  2008 
and  year-end  2013,  it  decreased  reserve  and 
liquidity 
in  various  steps  and 
implemented credit support schemes involving the 
Croatian development bank HBOR. However, with 
the  exchange  rate  as  the  monetary  policy  anchor 

requirements 

49 

 
 
                                                                                   
 
 
 
 
3. Imbalances and Risks 

The high degree of foreign ownership of banks 
in Croatia (Table 3.1) has generally been seen in 
a  positive  light.  There  is  evidence  that  foreign 
banks can play a stabilising role during crises and 
can bring benefits such as increased efficiency, the 
transfer  of  knowledge  (including  knowledge  of 
bank  management  and  risk  management)  and  the 
stability  of  lending  relationships. (41)    Foreign 
ownership  should  also,  in  principle,  help  to  limit 
linkages  between  the  sovereign  and  the  banks, 
notably  in  cases  where  additional  capital  may  be 
required.  However,  market  structure  is  highly 
concentrated, with the largest bank accounting for 
over  a  quarter  of  banking  assets,  and  the  two 
largest accounting for over 40%.  

(41)  Foreign  bank  presence 

is  associated  with  a 

lower 
probability of systemic banking crises, while foreign banks 
are also less likely to pull back from a host country in the 
face of problems (Demirgüç-Kunt, Levine and Min, 1998; 
Cull  and  Martinez  Peria,  2010).  Galac  and  Kraft  (2000) 
found  that  foreign  banks  in  Croatia  had  competitive 
advantages in terms of cheaper funding sources, lower loan 
interest  rates  and  superior  personnel,  but  the  impact  of 
foreign entry on competition and new product and service 
innovation was only modest. 

improvement 

and given the high level of euro-denominated debt, 
the  central  bank's  room  for  manoeuvre  remains 
limited.  An 
in  macroeconomic 
fundamentals, in particular export competitiveness, 
would  help  to  underpin  exchange  rate  stability  in 
the  medium-term  and 
for 
monetary  policy  to  support  the  recovery  of  the 
economy. 

increase 

leeway 

3.3.3.  The situation of the banking sector  

Croatia's  banking  system  is  characterised  by  a 
high degree of foreign ownership, minimal state 
presence,  and  capital  levels  among  the  highest 
in  the  region.  The  banking  sector  as  a  whole  has 
total  assets  of  EUR  54  billion,  or  about  130%  of 
domestic  GDP,  which  is  on  the  high  side  for  the 
CEE  region. (38)  There  are  around  30  banks  in 
Croatia, with the five largest, representing 75% of 
the system, being subsidiaries of banks from Italy 
and  Austria  (see  Table  1).  State  ownership  is 
limited to two banks, representing only around 5% 
of  total  banking  assets. (39)    Foreign  parent  banks 
of  Croatian  subsidiaries  generally  have  a  strong 
presence  in  the  region. (40)  In  line  with  the 
conservative  macro-prudential  approach  taken  by 
the  HNB,  the  reported  capital  adequacy  ratios  of 
the  largest  foreign  banks  stand  at  above  20%, 
while  liquidity  coefficients  remain  well  above  the 
minimum  required  ratios.  Mid-sized  banks  have  a 
reported  average  capital  adequacy  ratio  of  16.6%. 
Compared  to  large  banks,  mid-size  banks  are 
proportionally  more  exposed  to  corporates,  and 
less  exposed  to  the  government  and  the  retail 
sector. 

(38)  In the group of Central, Eastern and South-Eastern Europe 
(CESEE)  countries,  Croatia  has  the  fourth  largest  banking 
sector  when  measured  by  the  share  of  banking  assets  to 
GDP (after Cyprus, Malta and Slovenia). 

(39)  Hrvatska  Postanska  Banka  d.d.  is  the  eight-largest  bank, 
with EUR 2.2 billion of assets (around 4% of the total), and 
is in the process of being sold. Croatia Banka d.d., with a 
EUR  0.2  billion  balance  sheet  (less  than  0.5%  of  total 
assets), was put under a restructuring programme in 2010, 
and received state aid amounting to about EUR 30 million. 
The  current  owner  is  the  state  agency  responsible  for 
managing the deposit guarantee scheme. 

(40)  In  September  2013  the  European  Commission  approved  a 
restructuring  plan  for  Hypo  Group  Alpe  Adria  (HGAA), 
which  is  100%  owned  by  the  Republic  of  Austria  and 
which is the parent bank of Hypo Alpe Adria d.d., Croatia's 
fifth-largest bank. Under the plan, the operative parts of the 
bank  will  be  sold  while  the  non-viable  remainder  is  to  be 
put into an orderly wind-down process. 

50 

 
                                                           
                                                           
 
3. Imbalances and Risks 

Table 3.1:
Structure of the Croatian banking system

Bank name 

Ownership

Organisation 

Assets
    (bn EUR)

Assets (% of balance 
sheet)

Zagrebacka Banka d.d.
Privredna Banka Zagreb d.d.
Erste &Steiermarkische Banka
Raiffeisenbank Austria d.d.
Hypo Alpe-Adria-Bank d.d.

Largest five

Unicredit, Allianz
Intesa Holding Int., EBRD
ESB Holding GMBH
Raiffeisen Group, Reiffeisenbank
Hypo Alpe-Adria-Bank International AG

subsidiary, Italy
subsidiary, Italy
subsidiary, Austria
subsidiary, Austria
subsidiary, Austria

subsidiary, France

Societe Generale-Splitska Banka d.d. Societe General
Hrvatska Postanska Banka d.d.
OTP Banka Hrvatska d.d.
Largest eight

Republic of Croatia, Croatian Post, Croatian Pension Insurance Admin.
OTP Bank NYRT

subsidiary, Hungary

13.65
9.04
7.69
4.68
4.55
35.07
3.47

2.24
1.75
42.5

25.7
17.0
14.5
8.8
8.6
66.1
6.5

4.2
3.3
80.1

Source: HNB

One  of  the  major  challenges  facing  Croatian 
banks  is  the  high  level  of  NPLs  to  corporates, 
although  their  rate  of  increase  has  slowed 
recently.  The  protracted  weak  macroeconomic 
environment has had a significant effect on banks' 
asset quality. Overall NPLs reached 15.3% at end 
2013,  up  from  14%  one  year  earlier  and  5%  in 
2008  (Graph  3.40  and  3.41). (42)  This  effect  has 
been  strongest  in  the  corporate  sector,  with  NPLs 
at  27.4%  in  the  same  period,  up  from  24%  in  the 
previous  year.  Corporate  NPLs  are  highest  in 
the 
construction  and  real  estate  as  well  as 
wholesale  and  retail  trade  sector.  In  terms  of 
currency,  NPL  are  higher  for  CHF-denominated 
loans,  which  rose  from  35.8%  in  June  2011  to 
52.9% in September 2013. In comparison to other 
similar  GDP 
countries 
contraction 
in  recent  years,  NPLs  are  high. 
However,  the  year-on-year  growth  in  corporate 
NPLs slowed to 12% in 2013, from 23% in 2012. 
ratios  have  been 
While  provision  coverage 
increasing recently, they are low in comparison to 
other countries and the past. Since NPLs are one of 
the  main  channels  through  which  the  state  of  the 
economy  can  impact  banks'  balance  sheets,  their 
future  evolution  needs  to  be  closely  monitored.  It 
has  to  be  noted  that  some  corporate  loans  may 

that  experienced  a 

two 

factors  need 

(42)  The  national  classification  of  NPLs  in  Croatia  is  very 
similar to the standard, 90-days-past-due definition adopted 
by  the  EBA,  and  the  same  is  true  for  the  definition  of 
forbearance.  Nonetheless, 
to  be 
considered  with  regard  to  the  classification  of  risky  loans. 
First, loans remain classified as performing as long as there 
are no payment irregularities, even when the loan guarantor 
is  called  upon.  Second,  public  loans  benefiting  directly  or 
indirectly  from  a  state  guarantee  and  representing  a  large 
share of the banks' balance sheets could tend to be reported 
as  performing  even  when  the  underlying  project  is  in 
disarray.  Thus,  there  are  potentially  large  contingent 
liabilities for the state. 

need  to  be  restructured,  which  could  result  in 
higher  provisions,  but  in  some  cases  banks  might 
be  inclined  to keep  funding non-viable  businesses 
rather than take additional losses. 

Graph 3.40: NPLs and coverage ratio, Q3 2013

%

70

60

50

40

30

20

10

0

HR

BG

HU

RO

SI

NPLs

Coverage ratio

Source: HNB

Graph 3.41: Key financial indicators

30

25

20

%

15

10

5

0

50

40

30

20

10

0

%

NPLs, private sector
Capital adequacy ratio (CAR)
NPLs, corporate sector
Profitability, RoAE
Coverage of NPLs, banks (rhs)

Source: HNB; * - data for end-September

Domestic  banks  were  not  the  main  drivers  of 
the  rise  in  corporate  indebtedness.  As  noted 

51 

 
                                                           
 
 
 
 
 
 
 
3. Imbalances and Risks 

14

12

10

8

6

4

P
D
G

f
o
%

Graph 3.43: Banking and leasing assets

P
D
G

f
o
%

140

130

120

110

100

90

80

Banking assest (lhs)

Leasing assets (rhs)

Source: HNB

NPLs  in  the  household  sector  are  well  below 
those for corporates, but are also growing more 
rapidly.  At  the  end  of  2013  household  sector 
NPLs  stood  at  10.6%.  While  household  NPLs 
increased  relatively  rapidly  between  2008  and 
2010,  their  growth  subsequently  slowed.  More 
recently,  however,  there  has  been  acceleration  in 
the growth of household NPLs, from 10% year-on-
year growth in 2012 to 17% year-on-year in 2013, 
driven by a strong increase in NPLs for mortgage 
loans.  Despite  this,  household  NPLs  remain  well 
below the levels reported for the corporate sector. 
A  key  part  of  the  explanation  for  the  better 
performance  of  household  loans  seems  to  be  that 
payment  discipline  by  mortgage  borrowers  is 
relatively  strong  in  Croatia  compared  to  some 
other  countries,  while  loan-to-value  (LTV)  ratios 
did  not  rise  as  much  as  elsewhere.  However,  the 
evolution  of  household  NPLs  differs  with  the 
currency of denomination. In June 2011, NPLs for 
household  loans  stood  at  6.8%  in  both  the  euro- 
and  CHF-denominated  segments.  By  end-2013, 
NPLs for household loans rose to 13.3% for CHF-
denominated 
the  euro-
loans,  whereas 
denominated  portfolio  the  corresponding  figure 
was  8.6%.  While  banks  have  transferred  the 
exchange rate risk for these loans to the borrowers 
(many  of  whom  are  unhedged), 
the  strong 
preference  by  borrowers  for  foreign-currency-
linked  loans  does  create  indirect  credit  risk  for 
banks.  The  existence  of  this  risk  helps  to  explain 
why the HNB adopted a conservative approach to 
bank capital levels in recent years.   

in 

supply  during 

above,  various  macro-prudential  measures  limited 
the  role  of  domestically-supervised  banks 
in 
aggregate  credit 
the  2000s. 
Consequently,  the  rise  in  corporate  indebtedness 
was  mainly  driven  by 
increased  external 
borrowing,  with  a  prominent  role  played  by 
foreign  parent  banks  of  Croatian  subsidiaries 
(Graph  3.42).  The  credit  risk  for  these  loans 
remains  with  the  parents.  Similarly,  lending  to 
corporates  was  also  channelled  through  non-bank 
leasing 
financial 
companies, 
of 
the  HNB's  macro-prudential 
circumventing 
restrictions  on  banks.  All  large  international  bank 
groups present in Croatia have leasing subsidiaries 
generally  funded  through  parent  banks.  When 
leasing  companies  became  subject  to  stricter 
regulation,  the  sector  underwent  a  substantial 
deleveraging (Graph 3.43). 

intermediaries, 
again  with 

intention 

notably 

the 

Graph 3.42: Corporate debt evolution

n
b
K
R
H

300

250

200

150

100

50

0

02 03 04 05 06 07 08 09 10 11 12 13*

NFC Domestic debt (bank gross loans) NFC Foreign debt

Source: HNB; * data for end-September

52 

 
 
 
 
 
 
 
 
Bank liquidity conditions have been improving. 
With increased risk aversion by the private sector, 
deposit  volumes  have 
increased  and  deposit 
funding has become cheaper for banks. This along 
with more readily available domestic retail funding 
(deposits), has led to an improvement in the loan-
to-deposit ratio (Graph 3.44) and has also enabled 
the  large  banks  to  pay  back  foreign  liquidity 
sources  (credit  lines  and  interbank-loans)  and 
reduce  their  reliance  on  parent  funding.  This  has 
reduced  the  degree  of  funding  vulnerability  of 
Croatian  subsidiaries.  Conversely,  medium-sized 
banks  are  historically  more  reliant  on  domestic 
sources  of  funding  and  less  affected  by  potential 
foreign  deleveraging.  Loan-to-deposit  ratios  are 
lower  than  in  other  countries  that  experienced 
rapid  credit  growth  in  the  recent  past,  and  which 
should  support  a  revival  in  credit  growth  once 
demand picks up. 

Graph 3.44: Loans and deposits

103

102

101

100

%

99

98

97

6

4

2

%

0

-2

-4

-6

2
1
-
c
e
D

3
1
-
n
a
J

3
1
-
b
e
F

3
1
-
r
a
M

3
1
-
r
p
A

3
1
-
y
a
M

3
1
-
n
u
J

3
1
-
l
u
J

3
1
-
g
u
A

3
1
-
p
e
S

3
1
-
t
c
O

Loans to other residents
Deposits from other residents
Loan-to-deposit ratio (rhs)

Source: HNB

from 

interest 

to  earn 

remain  profitable,  but 
Croatian  banks 
profitability  has  nevertheless  come  under 
sources.  Rapid 
pressure 
several 
deleveraging in the corporate sector has meant that 
many loans are not being renewed, which reduces 
banks'  ability 
income.  Both 
deteriorating  asset  quality  and  deleveraging  are 
negatively  affecting  the  business  performance  of 
the  Croatian  banks,  while  margins  are  also  under 
pressure. Bank profits fell by 28% year-on-year in 
2012  and  by  preliminary  70%  year-on-year  in 
2013, but still remained positive and higher than in 
neighbouring  countries  throughout  the  crisis,  due 
in  part  to  the  high  flexibility  in  adjusting  interest 
rates  in  the  past,  as  well  as  to  improvements  in 

3. Imbalances and Risks 

operating efficiency more recently. In 2014 profits 
are expected to come under further pressure, given 
the  stricter  regulation  on  provisions  for  late-stage 
arrears  (an  increase  by  10%  a  year  independently 
of  collateral  valuations), 
the  new  minimum 
haircuts  on  property  collateral  valuation,  and  the 
reduction in lending volumes.   

Croatian  banks'  interest  margins  have  come 
under pressure. This is  mainly due to weak loan 
demand  from  households  and  NFCs,  and  a 
reorientation  of  lending  towards  less  risky  clients 
(the  general  government  sector  and  SOEs)  where 
the interest rate charged would typically be lower. 
Furthermore,  interest  income  has  also  fallen  as  a 
result  of  increasing  NPLs,  and  also  as  a  result  of 
the  different  regulations  on  the  setting  of  interest 
rates.  The  combined  impact  of  these  factors  is 
reflected  in  the  lowest  net  interest  margins  since 
2008  with  annual  net  interest  income  falling  to 
2.5%  of  average  assets  from  2.9%  in  2011. 
Although the interest margin is diminishing, there 
is little room for the banks to increase lending rates 
given the weak economy.  

The  various  measures  regulating  the  setting  of 
interest  rates  could  give  rise  to  a  number  of 
adverse  effects  for  the  economy  and  for 
borrowers.  There  are  three  different  types  of 
interest  rate  regimes  that  banks  are  obliged  to 
apply.  First,  on  retail  loans  denominated  in  Swiss 
Francs, a maximum interest rate of 3.23% was set, 
which  is  a  lower  rate  than  on  other  loans,  despite 
the fact that no new CHF-denominated loans have 
been sold for the past five years. Second, a ceiling 
has  been  imposed  on  the  maximum  interest  rate 
that  can  be  charged  to  clients  in  arrears  (11%  for 
retail  and  15%  for  corporates).  In  addition  to 
negatively  affecting  banks'  ability  to  earn  interest 
income, an adverse side effect of this regulation is 
that  it  may  not  be  profitable  for  banks  to  lend  to 
less creditworthy borrowers, and there is a risk that 
some borrowers could be forced to look for credit 
from  less  well  regulated  lenders.  Third,  in  setting 
interest  rates  to  clients,  banks  are  required  to 
choose one among five benchmarks plus a margin. 
Most  large  banks  have  chosen  Euribor,  which  is 
currently  at  historically  low  levels,  with  the 
consequence  that  interest  rates  for  clients  can 
likely only increase. Moreover, Euribor may not be 
a  reliable  indicator  of  Croatian  banks'  funding 
costs, given that they also have to internalise CDS 
spreads.  Although  this  particular  measure  was 

53 

 
 
3. Imbalances and Risks 

Table 3.2:

Capital and loan loss provisions analysis

Current Regulatory capital (net)

Total Risk weighted assets

Current provisions (Coverage ratio)

Additional provisions required

Total provisions required

Total NPLs

Total loans

New Regulatory capital (net)

Source: Commission services; HNB

Scenario 1:

current NPLs

Scenario 2:

NPLs lifted to 25%

provisions lifted to 60%

provisions lifted to 60%

in bn EUR

6.4

32.4

2.3

0.9

3.2

5.4

35.2

5.5

in %

19.8

43

17.0

60

15.3

16.9

in bn EUR

6.4

32.4

3.8

1.5

5.3

8.8

35.2

4.9

in %

19.8

43

17.0

60

25.0

15.1

taken  with  the  aim  of  increasing  transparency  for 
customers  about  the  lending  rates  that  banks 
charge,  it  risks  introducing  market  rigidities  and 
reducing  competition,  thus  potentially  leading  to 
counterproductive outcomes. Furthermore, it could 
limit  banks'  ability  to  supply  credit  to  the  real 
economy.  

Weak loan growth to the private sector appears 
to mainly reflect reduced demand for credit, as 
the  subdued  macroeconomic  environment  has 
led  households  and  NFCs  to  deleverage.  Given 
that Croatia has experienced five consecutive years 
of recession, demand for credit has fallen sharply. 
Weaker  credit  demand  stems  mainly  from  small 
and  medium-sized  enterprises  (SMEs)  and  in 
relation to long-term credit. Still, the HNB reports 
that  SMEs  continue  to  need  access  to  credit  for 
working capital purposes and to refinance existing 
debt,  but  that  they  are  facing  tighter  credit 
standards. (43) According to the latest EIB CESEE 
lending  survey,  credit  supply  conditions  for 
mortgages,  large  companies  and  long-term  loans 
have tightened and are expected to continue doing 
so in the next months. Tighter credit standards are 
partly  a  consequence  of  banks'  increased  risk-
aversion, which is not only due to the interest rate 
caps, discussed above, but also due to the need to 
keep  risks  and  capital  under  control.  The  EIB 
survey  found  that,  while  credit  demand  remains 

(43)  The  tightening  of  credit  conditions  may  partly  reflect 
stricter  Austrian 
requiring 
supervisory 
subsidiaries to reduce their loan-to-deposit (LTD) ratios to 
below 120%. 

guidance 

54 

weak, it is expected to expand slightly, also due to 
the positive impact of debt restructuring actions.  

Banks  have  responded  to  reduced  private 
demand  for  credit  by  increasing  the  supply  of 
loans to state entities, but this could give rise to 
problems further down the road. Total loans by 
monetary  financial  institutions  to  the  Croatian 
economy  peaked  at  EUR  46.9  billion  in  March 
2012. Since then, loans to the general government 
sector and SOEs have increased, while loans to the 
rest  of  the  economy  have  fallen  (see  Box  3.6.). 
Loans  to  the  private  sector  have  contracted  by 
EUR  2.2  billion  or  almost  5%  from  their  peak, 
which  has  been  mainly  driven  by  the  strong 
reduction of loans to NFCs. By October 2013 bank 
credit  to  NFCs  had  declined  by  12.6%  from  the 
peak  in  March,  while  credit  to  households  had 
fallen by 4%. Weak loan demand from households 
likely  reflects,  among  other  things,  worsening 
labour  market  conditions,  notably  the  increase  in 
the  unemployment  rate.  In  contrast,  loans  to  the 
general  government  have  been  rising,  reaching 
11% y-o-y growth in the first ten months of 2013 
(see  Graph  4  in  Box  3.1).  Viewed  from  a  pure 
banking/credit-risk  perspective,  an  increase  in 
loans to SOEs may not necessarily be problematic 
provided 
creditworthy. 
However, a continuation of these trends would be 
incompatible  with  a  reduced  role  for  the  state  in 
the economy. There may also be doubts about the 
longer-term viability of many SOEs. Furthermore, 
there  are  important  contingent  liabilities  for  the 
government  associated  with  guarantees  to  SOEs. 

enterprises 

the 

are 

 
                                                           
 
 
 
 
3. Imbalances and Risks 

Finally, it will be important to ensure that there has 
not been a structural shift in banks’ risk appetite to 
the detriment of newer, private companies. 

55 

 
3. Imbalances and Risks 

Box 3.6: Banks’ exposure to the general government and SOEs

The  growth  of  loans  to  the  central  government  has  increased  almost  constantly  since  2011  (from  9.8  to 
12.3% of GDP). While these levels are high when compared to other CEE countries, they are not out of line 
with figures for the euro area (Graph 1a). Loans to the central government represent about 10% of banking 
assets  (EUR  5.5bn)  and  are  concentrated  in  the  large  private  banks.  The  increase  stems  from  the  fall  in 
demand  for  credit  from  the  private  sector  and  enables  the  banks  to  partially  compensate  for  the  reduced 
interest income, while also limiting credit risk. 

While loans to the corporate sector contracted by 4% y-o-y in September 2013, this figure masks different 
trends  between  private  corporates  and  state-owned  enterprises  (SOEs).  Croatian  SOEs  represent  13%  of 
corporate income but absorb 23% of corporate loans. (1) Whereas the volume of loans to private corporates 
had  dropped  by  9%  in  September  2013  on  a  y-o-y  basis,  bank  credit  to  SOEs  increased  by  10%. Besides 
demand factors, banks may consider SOEs to represent a lower credit risk than other NFCs. State guarantees 
(whether explicit or implicit (2)) as well as their sector of activity often tightly linked to public services (e.g. 
utilities) may also be a factor behind the perceived lower credit risk of the sector. However, such a credit 
policy may lead to a misallocation of capital within the Croatian economy, and can hinder needed corporate 
sector restructuring, notably of SOEs with questionable viability. To the extent that it continues, there is also 
a  risk  that  privately-owned  firms,  and  especially  newer,  more  innovative  companies,  may  not  be  able  to 
contribute  strongly  to  Croatia's  recovery,  as  they  may  be  at  a  disadvantage  in  terms  of  access  to  credit 
compared to SOEs.  

Holding of sovereign securities by Croatian banks represent 8% of bank assets and 9% of GDP. They were 
on a modestly increasing path up to the first quarter of 2013, but holdings have declined since then (Graph 
1b).  Holdings  of  government  securities  also  are  instrumental  for  banks  to  fulfil  liquidity  requirements  as 
well as to be able to access central bank liquidity in case of need. The large majority of bonds (around 90%) 
are held by the largest banks, while small banks hold mostly Treasury bills. 

Graph 1a: Loans to central government

Graph 1b: Holdings of government securities 

14

12

10

8

6

4

2

P
D
G

f
o
%

0
2011-12

2012-05

2012-10

2013-03

2013-08

BG
HU

CZ
PT

HR
SI

LV
EA

LT
RO

Source: ECB 

25

20

P
D
G

f
o
%

15

10

5

0

2
1
-
1
1
0
2

2
0
-
2
1
0
2

BG
PL

Source:  ECB

4
0
-
2
1
0
2

6
0
-
2
1
0
2

8
0
-
2
1
0
2

0
1
-
2
1
0
2

2
1
-
2
1
0
2

2
0
-
3
1
0
2

CZ
RO

6
0
-
3
1
0
2

8
0
-
3
1
0
2

0
1
-
3
1
0
2

4
0
-
3
1
0
2

HR
EA

2
1
-
3
1
0
2

HU
SI

The  reallocation  of  banks'  credit  portfolios  towards  public  sector  entities  (central  government  and  public 
enterprises) discussed above has allowed banks to partially compensate for the downward pressure on their 
profitability as a result of weak credit demand from the private sector. Indeed, this development may be one 

(1)  The  Government  Asset  Management  Company,  which  manages  the  Croatian  firms  with  direct  government 
ownership, has more than 600 firms in its portfolio. Most likely there are many more firms with some minor share of 
public sector ownership or indirect state ownership. 

(2)  Loans  to  public  institutions  benefit  from  a  zero  risk-weighting  for  capital  purposes,  but  loans  to  SOEs  with  a 

commercial purpose do not. 

(Continued on the next page) 

56 

 
 
 
 
 
 
 
 
                                                           
 
 
3. Imbalances and Risks 

Box (continued) 

of  the  factors  that  has  allowed  Croatian  banks  to  achieve  higher  profitability  levels  than  banks  in  other 
countries in the region over recent years (with return on average assets rising to 1.3% and that on average 
equity to 6.8%). But these trends need to be monitored closely to ensure that credit is not being misallocated. 

Balance  sheet  repair,  together  with  other 
initiatives,  should  help  strengthen  the  capacity 
of  banks  to  support  the  economy.  Factors  that 
are  weighing  on  bank  profitability,  and  thus 
constraining  their  ability  to  lend,  include  the  high 
stock  of  NPLs  coupled  with  inefficiencies  in  the 
court  system  that  may  hinder  banks’  ability  to 
work  through  NPLs.  Recent  revisions  to  the  pre-
bankruptcy  procedure  should  help  with  this.  An 
additional  positive  factor  is  the  various  parent 
banks’  initiatives  to  dispose  of  bad  assets  within 
their  groups,  which  might  help  to  release  new 
resources  for  lending  over  the  next  year.  The 
European Commission and EIB are also proposing 
an  initiative  to  boost  lending  to  SMEs,  by 
providing  funds  from  the  two  institutions,  and  to 
allow  for  risk  sharing  and/or  guarantees  for 
the  commercial  banks.  Such 
funding 
initiatives are potentially very useful, especially if 
the  environment  is  characterised  by  heightened 
risk aversion, but care should be taken by banks to 
avoid compromising lending standards. 

from 

High capital levels should allow Croatian banks 
to accommodate any further needed increase in 
provision  coverage  ratios.  Despite  increasing 
recently, provision levels are lower than in the past 
but  higher  capital  levels  provide  an  important 
buffer. The provision coverage ratio stood at 43% 
at end 2013, and including a general provision for 
performing  loans,  it  was  at  49%. (44)  While  the 
coverage ratio has increased rapidly during the last 
year  (also  due  to  the  new  supervisory  regulation 
introduced in June 2013 on additional haircuts for 
the property collateral), it is still low compared to 
the past (it stood at 52% in 2007) and compared to 
the euro-area average of around 60%.  

A  simple  sensitivity  analysis  appears  to  show 
that  Croatian  banks 
remain  adequately 
capitalised  for  now.  With  a  reported  core  capital 
adequacy  ratio  of  19.8%  at  end-September  2013, 
banks  in  Croatia  are  capitalised  much  above  the 

(44)  The  HNB  estimates  that  the  new  requirement  on  higher 

provisioning reduced banks' profits by 37%.   

the 

and 

above 

averages 

EU 
Basel 
requirements. (45)  A  simple  sensitivity  analysis 
shows that with the provisioning coverage ratio at 
60% and NPLs at 25%, capital adequacy would be 
reduced to 15%, which is still above the minimum 
requirement  of  13%  (Table  3.2).  These  buffers 
seem  to  be  high  enough  to  cover  future  potential 
losses.  However,  this  conclusion  is  obviously 
preliminary,  since  it  is  not  based  on  any  in-depth 
analysis of individual banks' balance sheets.  

in 

that 

the  exercise  might  be 

The  four  largest  Croatian  subsidiaries  will 
participate 
the  ECB  Comprehensive 
Assessment exercise via their parent banks. The 
Comprehensive  Assessment  exercise  will  be 
undertaken  by  the  ECB  and  the  relevant  national 
competent authorities during 2014 in the context of 
the  Single  Supervisory  Mechanism  (SSM).  It  will 
consist  of  a  supervisory  review,  an  asset  quality 
review  and  a  stress  test.  It  should,  however,  be 
recognised 
less 
informative about the situation of Croatian banking 
sector, as selection of loan portfolios will be done 
on  a  banking  group  level,  and  thus  may  not  fully 
reflect  the  circumstances  of  Croatian  subsidiaries. 
In view of this, there is scope to consider whether 
additional  supervisory  diagnostic  actions  can  be 
taken  from  a  Croatian  perspective  to  complement 
the Comprehensive Assessment and, thus, provide 
any  needed  additional  information.  The  SSM  will 
move the supervision of parent groups of the main 
Croatian  banks  to  the  ECB,  and  will  represent  an 
opportunity to strengthen cross-border supervision 
and  cooperation  between  home 
and  host 
supervisors,  including  also  for  non-SSM  host 
supervisors, such as the HNB. 

While  banks'  asset  quality  may  be  affected  by 
any  further  falls  in  property  prices,  notably 

(45)  Macro-prudential  tools  in  place  between  2004  and  2008 
(high  reserve  requirements  on  banks'  foreign  liabilities, 
high  foreign  currency  liquidity  requirements)  boosted 
banks'  capital  positions,  as  they  induced  foreign  parent 
banks  to  provide  a  large  part  of  financing  in  the  form  of 
equity. 

57 

 
                                                           
                                                           
 
 
 
 
 
3. Imbalances and Risks 

whether  it  leads  to  a  timely  restructuring  of  firms 
(from  both  an  operational  and  a  debt  perspective) 
and  whether  it  enables  the  restructured  firm  to 
emerge as truly viable at the end of the process and 
therefore capable of accessing credit.  

through  collateral  valuation,  there  are  factors 
which  should  help  to  mitigate  this  risk.  House 
prices  in  Croatia  nearly  doubled  in  the  five  years 
leading  up  to  2008,  and  since  then  have  declined 
by  approximately  30%  (Graph  3.45). (46)  In 
parallel,  deleveraging  in  the  real  estate  sector 
started  at  the  end  of 2012. However, banks  are  to 
some  extent  protected  against  real-estate  related 
risks, due to relatively low loan-to-value ratios and 
to guarantees. Nevertheless, aware of the risks that 
further  falls  in  property  prices  could  potentially 
have  on  banks'  balance  sheets, 
the  HNB 
conservatively  introduced  additional  haircuts  on 
property collateral in June 2013 (see above). 

Graph 3.45: Property price index

120

100

80

60

40

20

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13*

Croatia

Zagreb

Sea-side area

Source: Commission services calculations; HNB; * - Q1-Q3

The efficiency of the legal system will affect the 
ability of banks to work through problem loans. 
A  well-functioning  legal  system  can  be  helpful  in 
speeding  adjustment 
to,  and  recovery  from, 
property  price  shocks.  For  example,  impediments 
to  banks'  ability  to  realise  the  value  of  loan 
collateral  would  likely  mean  that  such  collateral 
would  only  re-enter  the  market  with  a  significant 
lag.  In  relation  to  corporate  loans,  the  Croatian 
authorities introduced a pre-bankruptcy framework 
in  2013, 
the  restructuring  and 
repayment  process  of  companies  in  distress  and 
avoid  the  lengthy  bankruptcy  procedure  as  far  as 
possible  (see  Box  3.4.).  This  new  pre-bankruptcy 
procedure got off to an imperfect start, however, in 
part due to legal loopholes, and had to be revised. 
It  remains  to  be  seen  whether  it  appropriately 
balances  the  rights  of  creditors  and  debtors, 

to  speed-up 

(46)  Source: Financial Stability Report, 2013. 

58 

 
 
                                                           
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
    
4. 

POLICY CHALLENGES 

POLICY CHALLENGES 

After  an  expansionary  phase, 
in  which 
is  now 
imbalances  accumulated,  Croatia 
experiencing a prolonged downturn, in which a 
range  of  external  and  internal  risks  have  come 
to  the  fore.  The  current  account  reversal  since 
liabilities, 
2009  has  exposed  high  external 
uncompetitive  exports,  a  corporate  debt  overhang 
indebtedness  as  particular 
and  public  sector 
vulnerabilities.  Structural 
have 
deficiencies 
contributed  to  these  imbalances,  including  a  poor 
business environment and a malfunctioning labour 
market.  State-owned  enterprises  still  play  a 
dominant  role  in  some  sectors  and  they  are  often 
highly  indebted  and  weakly  profitable.  These 
factors  also  combine  to  lower  potential  growth, 
which  hinders  private  sector  balance  sheet  repair 
and  increases  the  required  fiscal  consolidation 
effort.    

External sustainability and exports 

is 

on 

with 

conditioned 

Greater  sustainability  of  Croatia's  external 
position 
improved 
competitiveness and broadening exports beyond 
tourism  to  support  growth.  Although  labour 
costs  have  grown  moderately  since  2009  in 
comparison  with  competitors,  these  trends  will 
only bring labour costs down to competitive levels 
if  sustained  and  would  yield  greater  benefits  if 
non-cost-competitiveness 
combined 
business 
the 
improvements, 
environment.  These  are  preconditions  for  Croatia 
to attract high-quality FDI, regenerate its industrial 
fabric,  rebalance  and  lay  the  foundations  for 
sustainable  growth  and  the  creation  of  jobs.  The 
maintenance of strong, stability-oriented monetary 
and fiscal policies is a strategic imperative, in view 
of  high  external  liabilities,  and  the  extent  of 
foreign-currency-denominated  obligations  of  the 
financial, non-financial and public sectors.  

including 

in 

credit is correctly allocated within the economy as 
deleveraging  continues.  The  orientation  of  bank 
lending  within  the  corporate  segment  could  be 
monitored,  especially  in  view  of  debt  levels  and 
doubts as to long-term viability of some publicly-
owned entities. Removing some of the restrictions 
on  banks'  ability  to  set  interest  rates  can  also 
contribute  to  efficient  financial  intermediation. 
Close  monitoring  and  supervision  of  systemic 
banks will continue to be important, in cooperation 
with home country supervisors. In this respect, the 
ongoing  ECB  comprehensive  assessment  exercise 
will  include  the  four  largest  Croatian  banks, 
through their respective parents. There is scope to 
consider  complementing 
this  with  additional 
supervisory  diagnostic  steps  from  a  Croatian 
perspective. 

public 

credible 

structural 

for  high-quality, 

With  reference  to  the  risks  to  the  current 
trajectory  of  public  debt,  there  is  a  pressing 
need 
fiscal 
consolidation  measures  amounting  to  a  clear 
finance 
and 
overall 
the 
consolidation  strategy.  Compliance  with 
targets  contained  in  the  EDP  and  thereafter  with 
the  requirements  of  the  SGP  would  ensure  that 
Croatia's debt is on the sustainable path. A number 
of  supporting  polices  can  be  considered.  Tax 
shifting  towards  less  mobile  factors  could  boost 
labour  market  participation  and  growth  and  yield 
second-round 
asset 
disposals  and  concession  agreements  could  yield 
proceeds  to  pay-off  debt  and  reduce  fiscal  risks 
from  the  potential  socialisation  of  losses  incurred 
by  publicly-controlled  enterprises.  Substantial 
reductions 
improved 
targeting of social benefits, a more effective social 
protection  system,  together  with  credible  fiscal 
institutions  and  rules  at  all  levels  of  government, 
could  help  support  sustained  deficit  and  debt 
reductions.  

fiscal  benefits.  Further 

in  subsidies 

firms, 

to 

Indebtedness and deleveraging 

Growth,  employment  and 
environment 

the  business 

In view of private sector over-indebtedness, it is 
important to ensure the conditions for a smooth 
the  deleveraging  process, 
continuation  of 
functioning  of 
including 
insolvency  and  debt-restructuring  regimes. 
Correctly 
intermediation 
would  also  be  beneficial,  notably  to  ensure  that 

through  proper 

functioning 

financial 

for 

in  recession 

Croatia  has  been 
five 
consecutive years and only a muted recovery is 
in sight. Growth and employment are desirable as 
ends  in  themselves  but  would  also  ease  private 
sector  deleveraging, 
ratios, 
strengthen  banks  and  make  external  liabilities 
more sustainable. Therefore, the structural reforms, 

improve 

fiscal 

59 

 
4. Policy Challenges 

including of the labour market, became ever more 
important. This would be complemented by efforts 
to efficiently mobilise EU funds to boost potential 
growth in the wider economy. 

in 

the 

The  scale  of  the  employment  shortfall  and  of 
economic adjustment represents a major policy 
challenge.  The  employment  rate  has  been  the 
lowest  in  the  EU  since  2009,  and  stayed  low 
throughout the economic cycle. Reforms currently 
under  way 
labour  market  could  be 
accompanied by  flanking  initiatives  to  boost  legal 
certainty  and  increase  the  speed  and  efficiency 
with  which  employment  cases  are  considered  by 
the  courts.  A  comprehensive  response  could  also 
involve,  where  necessary,  adjusting  a  number  of 
institutions  and  policies  affecting  labour  market 
functioning.  Building  on  recent  steps  to  improve 
targeting  of 
social  benefits,  unemployment 
assistance  and  other  benefits  could  be  revisited  to 
reduce  inactivity  traps.  Closely  monitoring  and 
enhancing  the  effectiveness  of  Active  Labour 
Market Policies, while increasing their coverage of 
vulnerable  groups,  would  help 
to  address 
unemployment and skills mismatches.  

in 

to 

the 

promote 

the  need 

rebalancing 

policies 
and 

for 
The  authorities  recognise 
orderly 
structural 
and  boost 
adjustment 
competitiveness.  Some  steps  have  been  taken  in 
this direction. Recently adopted measures include, 
among  others,  changes 
investment 
promotion legislation that simplify procedures and 
introduce  new 
investors,  and 
streamlining  of  social  contributions  to  encourage 
labour  force  participation.  The  authorities  have 
also  introduced  amendments  in  the  bankruptcy 
legislation  aimed  at  significantly  facilitating  exit 
from  the  market  and  have  simplified  procedures 
for  granting  construction  permits  in  an  attempt  to 
revive the sector.  

incentives 

for 

60 

 
 
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