# **Introduction**

Croatia has been heavily affected by the global economic crisis and per capita GDP has remained stagnant since 2009. The country experienced sustained and relatively high rates of economic growth during the years preceding the global crisis. This was the result of a boom in domestic investment and consumption financed by large inflows of foreign capital. However, the Croatian economy was seriously affected by the global economic crisis and the local economy has been in recession since 2008. After plunging to -7 percent in 2009, growth has remained negative and registered -0.6 percent in 2013. This performance lags behind that of many new EU member states which have managed to achieve positive growth starting with 2010.<sup>1</sup> Unemployment remains a challenge and has continued to worsen, reaching 16.6% in 2013,<sup>2</sup> significantly higher than in many comparator EU members.

The poor economic record of recent years can be traced in large measure to a lackluster trade performance. Croatia’s openness to trade is lower than what would be expected when considering the country’s income per capita level. The economy has been particularly affected by the recession in the Eurozone as approximately half of its export activity is concentrated in the Euro-area, which is also the source of about three-quarters of foreign direct investment in the country. While Croatia’s goods and services balance is neutral, the country posts an important deficit in goods trade. In addition, export competitiveness, as measured by export market share changes, even declined. Sectoral specialization, market orientation, and domestic supply-side factors all concurred to the negative performance. Although the level of complexity of local exports is higher than its level of income would suggest, it lags behind regional peers. The main export sectors are furthermore low in capital content and dominated by industries where price competition is more important than competing in terms of quality.

In order to better understand the country’s export dynamics and inform policy solutions, it is important to analyze trade performance not only at the national but also at the local level. It has been recognized that the main challenges which shape trade patterns and development are different based on geographic scale. This is because, far from being uniform, economic activity and growth tends to become spatially concentrated over time. In the case of Croatia, although all of its regions contribute to the country’s export activity, export performance varies significantly across counties. The goal of this paper is to shed some light on the differences in export performance between Croatian counties.

_In the first stage_ , this paper uses the gravity model to analyze whether the varying export performance of Croatian regions can be explained by their proximity to export destinations. The gravity model is probably one of the most empirically successful models in the trade literature and shows that geography and distance can explain a significant portion of the variation in trade flows and that trade volume is negatively correlated with the distance between trading partners.

> 1 These include: Poland, Lithuania, Hungary, or Bulgaria (source IMF WEO Database)

> 2 IMF World Economic Outlook (October 2013) estimates

2