WB Croatia Country Office Economic Highlights Croatia, June REAL SECTOR

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1 WB Croatia Country Office Economic Highlights Croatia, June After 3.7 percent real growth in 2000, all quantitative indicators suggest the annual growth rate for 2001 could be around 4 percent. Financial indicators, captured through the operational revenues of legal entities realized by April, grew by 19.4 percent nominally y-o-y. Double-digit growth rate of imports of capital goods (filtered for the car imports) at 33.4 percent by May and 8.6 percent higher commercial sector lending to enterprises by April, suggest the revival of investment activities. After six quarters in a row of negative investment rates it seems that the investment activity picked up. New preliminary data on GDP growth in Q confirmed the expectations: the growth rate was 4.2 percent, with investment and personal consumption being the main driving force of growth. Fiscal deficit is still being on the up side at around 2.3 percent of GDP by May, while the public debt with only financial sector guarantees hit the level of 49 percent of GDP. Parliament has just adopted first budget revision for the year and announced another one for the fall. The first budget revision was of more technical character: introduction of the Pension Fund operations under Single Treasury Account, creating the equalization fund for fiscal decentralization to start on July 1, and replacing too optimistically budgeted privatization receipts with the new borrowing requirement of HRK 2 bill. Although the newly budgeted deficit is in line with the IMF SBA quantitative criteria, some fiscal developments require quick expenditure retrenchment program. Ahead of the approval of budget revision, Fitch IBCA upgraded Croatia's sovereign long-term local and foreign currency ratings to BBB- from BB+ with a stable outlook. Unemployment declined for the third consecutive month due to strong seasonal effect. However, double-digit increase in vacancies suggests potential reduction of unemployment even after the tourist season ends. Apart from the positive impact of industrial production recovery and growth of service sector on job creation, wage subsidies given through tax incentives seems to become attractive to entrepreneurs. After successfully completing the Stand-By Agreement with the IMF in March, negotiated the Stabilization and Association Agreement with the EU in May, at the beginning of June, Croatian Government successfully finalized negotiations on USD 202 mill SAL. The 18-months loan is aimed to support economy-wide reforms through: improving economic policy-making, enhancing fiscal discipline, strengthening market institutions and the competitiveness of the economy, enhancing flexibility in the labor market, and strengthening the social safety net to alleviate the adverse effects of restructuring program. REAL SECTOR Growth rate of 4.2 percent in Q1 After achieving 3.69 percent of GDP growth in 2000, Croatian economy grew by 4.2 percent in Q The main growth contributors, being personal consumption, exports and investments, point to the switch in growth trend components. After six quarters in a row of negative investment rates, Q1 shows a recovery. Real investments grew by 11.6 percent, personal consumption by 5.3 percent, exports by 4.3, while government consumption declined by 2.7 percent. Elimination of the tax exemptions on the car imports after June pushed the imports in the first quarter by 11.7 percent the trend observed last time in Q However, double-digit growth rate of imports of capital goods less car imports, at 33.4 percent by May, and 8.6 percent higher commercial sector lending to enterprises by April, suggest the continuum of investment revival in the coming months. Figure 1: GDP Growth (constant 1997 prices) Quarterly GDP at Constant Prices (1997=100), growth rate over previous year 1998:I II III IV 1999:I II III IV 2000:I II III IV 2001:I GDP growth P ersonal consumption Investments Expo rts o f GNFS Figure 2: Trend Cycle of Industrial Production (95=100) % Stocks of finished products Industrial production

2 WB Croatia Country Office Economic Highlights Croatia, June Positive trend, started in 2000, is also visible in the fact that the share of public consumption fell by 1.3 percent in real terms as compared to 1999, and that public consumption on accrual basis continued declining in 2001 as well. According to NCEA classification the highest growing sector was wholesale and retail trade (15.5 percent), followed by transport, storage and communication (6.6), construction (6.1), financial intermediation and manufacturing (3.9 both). Agriculture grew by only 2.2 percent. Hotels and restaurants and government sector declined by 3.8 and 0.4 percent, respectively. Industrial Production on the Rise After the poorly performing Q4 of 2000, industrial production started steadily growing throughout May this year. Except for February, all other months have registered high, in some cases even double-digit, growth rates. In May alone, industrial production grew by 8.2 percent y-o-y, while cumulative growth was 7 percent. According to main industrial groupings (MIG) classification, production of capital goods rose 37.7 percent, while production of intermediate goods (except energy) and non-durable consumer goods, with two highest weights of 32 and percent in the total industrial production, increased 3.3 and 8.1 percent respectively. Energy production has been stagnant in the observed period. If taking a look at the NCEA classification, manufacturing sector growth increased by 8.5 percent y-o-y, and has been the main growth leader by May. Out of 27 sectors divisions, only 6 declined. Manufacturing of food products and beverages, with the highest share in the industrial production structure, grew by 4.3 percent. The fall in stocks and growth in exports signaled the production growth in later months. Therefore, consecutive decline in stocks of finished goods in the last four quarters (cumulative decline by May was 1.1 percent) signals the potential further growth of industrial production in early summer months. The same prediction came from the ICI Industrial confidence indicator, which projected strong growth of industrial production in the second quarter and moderate positive growth in Q Table 1: Growth rates of the main industrial production components for Q %, y-o-y (weights in industrial production) Food and beverages (21.42) Electricity, gas, steam and hot water supply (11.46) Chemicals and chemical products (8.16) Publishing and printing (6.12) Other nonmetallic mineral products (5.16) Fabricated metal products (4.16) Ships (4.02) Machinery and equipment (3.78) Wearing apparel, dressing (3.5) Extraction of crude petroleum & natural gas (3.38) Coke and refined petroleum products (3.2) Industrial production* Exports Stocks Imports * For the Jan-May period A 10-Percent Stronger Tourist Season expected in 2001 Nights spent by tourists in Q grew by 6.4 percent. Having in mind weak last years Q1 results, this is seen as rather stagnating, especially when compared to the same period in 1999, pre-kosovo crisis period. However, April brought good news; it boosted the number of tourists by 15.8 percent (cumulative growth being 9.7 percent). The number of arrivals surged by 9.5 percent as well. As a contrary to year 2000, in the first four months of 2001 there were 12 percent more foreign tourists arrivals, but also 6 percent more domestic tourists. Official data show that there were 2.1 million tourist-nights by April, and the moderately expected outcome for the year is around 42 million nights or some 10 percent more than last year. According to the data collected by the Bureau of Statistics, length of stay is 2.9 nights by tourists. The biggest number of foreign tourists came from Germany (23.8 percent of total), followed by tourists from Italy (16 percent), Austria (16 percent) and Slovenia (15.7 percent). The foreign currency inflow from the tourism expected for the year 2001 is 13 percent higher than the last year. The assumption behind that is that other-than-hotel tourist consumption will grow, now that accommodation charge for those tourists who come through organized foreign tour-operators has become cheaper (as from the last year this service is on zero VAT rate). Surge in Retail Trade Cumulative increase of real retail turnover over the first four months stands at 11.5 percent, compared to the same period of High rate of growth continued to exercise since the beginning of the last year, due, to a high extent, to the stronger lending activity to households that started in Q Real wages on the contrary registered a fall (gross wage) or stagnation (net wage). Most of the lending finished in the imports of cars, which was by May

3 WB Croatia Country Office Economic Highlights Croatia, June as high as 470 mill USD (12.7 percent of imports or 25.8 percent of the total Croatian exports). Namely, war veterans and survivors families have the right to execute their benefit to duty-free imports only by the end of June. The same pattern of trade and imports has been observed back in 1997, when Croatia reached 11.7 percent of GDP current account deficit due to the rush to import a duty-free car. Trade was growing by double-digit rates, but country needed two years to recover from such a high external imbalance. Hopefully, this will diminish after Q2 when the trade growth will be based on tourist consumption. Figure 3: Trade and Household Income Figure 4: Monthly Chain Indices of Prices 6,000,000 5,500,000 5,000,000 (000 HRK) Real retail turnover Real disposable personal income ,500, ,000,000 3,500, ,000,000 2,500, ,000, ,500,000 1,000, CPI PPI Inflation is Stable As oil prices have stabilized, the inflation in Croatia remained flat in May as compared to April, reaching 6.8 percent at annual level. This is still the highest inflation level since In the course of 2000 the inflation reached 6.2 percent, mainly due to the Government decision to allow price adjustments to its oil company (INA) and the state Electricity Company (HEP). On the aggregate level, retail prices of goods grew 6.5 percent in 2000, while the increase in prices of services was somewhat lower, at 5.1 percent. In the first five months of 2001, goods increased by 7.2 percent, while services grew by 5.4 percent. The highest growing group is liquid fuels and lubricants, prices of which were driven by the INA s twofold adjustment of prices in April 2001: Government introduction of road charge of HRK per liter (including VAT) into the oil price and new calculation formula for determining the price of oil derivatives (based on oil prices on Mediterranean market and dollar exchange rate). Although the indirect effects of oil price adjustment onto the prices of other goods and services will be absorbed in the next several months, core inflation remained below 5 percent by May. Producers prices rose by 9.7 percent in 2000 due to the one-time effect of energy prices adjustments. When comparing with such a high base, the inflation measured by producers prices fell to 6.4 percent level by May this year. While rises in prices of capital goods, intermediate goods, durable and non-durable consumer goods remained in a reasonable -0.1 to 3.7 percent range, producers prices of energy increased as much as 17.5 percent in the observed period. The Croatian government sent to Parliament a set of laws aimed at liberalizing and regulating the production and sale of electric power, oil and gas. The laws are expected to go for a second reading by the Parliament in mid- July and come into effect in early The government plans to liberalize the sector to allow free supply of power, oil and gas, which are currently state monopolies. The outcome of this action will be some upward adjustment of prices at the beginning, but also under the influence of higher competition on the market, the fall in utilities prices can be expected in the second stage. LABOR MARKET Unemployment on Decline Better Days to Come? Following a seasonal pattern of lower unemployment during strong tourist season due to the employment of temporary workers, the total number of unemployed persons has fallen by 4 percent in May as compared to its peak in February this year. According to the Employment Service data, there are still 8.4 percent more unemployed persons in the first five months of 2001 than in the same period last year. The average number of first-time job seekers was 4.4 percent higher than in However, the increased number of vacancies by 40.8 percent suggests potential higher employability during the following next months. The coverage of unemployment by vacancies was only 3.4 percent in January, while it was 6 percent in May the highest share in the last several years.

4 WB Croatia Country Office Economic Highlights Croatia, June Tax incentives given in January amendments to the Profit tax law for the wage bill of newly employed being deductible from the tax base, together with the falling labor costs and increased foreign and domestic demand, initiated employers to open vacancies. The extent of job creation from the first five months suggests a potential unemployment fall in autumn months as well. Seasonally adjusted data on employment growth in legal entities and crafts suggest a modest increase in private sector employment. The educational background of unemployed, however, is rather unfavorable: 69 percent of unemployed has less than a secondary-school education, approximately the same share as in 2000; 41 percent of unemployed are younger than 30 years, while 12.5 percent are more than 50 years old. The active labor market policies will have to be specially curtailed for older generation, if one wants to reduce the pressure on the Pension fund. Namely, redeployment chances of older generations with such a high share of younger unemployed are less clear. Figure 5: Unemployment Trends 400, , , , ,000 unemployed - original unemployment-seasonally adjusted Figure 6: The Age Structure of Unemployed % % % % % % 300, , , , , / / / / / / / / / / / / % % % % According to ILO comparable survey data, unemployment rate in the second half of 2000 grew again, from 15.1 percent to 17 percent. This figure does not include the persons in wage employment who are not being paid (additional 66 thousand). However, wage arrears declined as compared to the first half of the year, when there was 87 thousand worker being unpaid. Unemployment rate in the second half of the year was the highest among young persons (15 to 24), standing at 43.1 percent, while the share of inactive persons of working age increased by additional 31 thousand. When compared to other transition countries in Europe, Croatia has the highest unemployment rates, but also the highest difference between administratively registered unemployment (21.3) and ILO unemployment rate. Around 15 percent or 98 thousand people registered as unemployed were working on a temporary basis in the underground economy. However, there was still some 56 thousand people who were not registered at the Employment Service, but were unemployed according to the international criteria. Table 2: Activity and unemployment rates (ILO comparable) 1999 H H H H2 Unemployment rate, % Activity rate, %** * H half of the year **Labor force in working age population Population 4,373,000 Working age (15+) 84.7% Inactive 48.9% Employed 42.4% Unemployed 8.7% Wage employment 33.19% of working age Self-employment 7.5% of working age In private sector 14.5% In state sector 17.1% In sector being privatized 1.6%

5 WB Croatia Country Office Economic Highlights Croatia, June Wage Freeze in the Public Sector; Pensions on Rise Nominal average net wage went above 3500 HRK or some 426 USD already at the end of 2000, but remained at the same nominal level up to the end of the first quarter. The cumulative growth of net wage in 2000 was 8.9 percent, and it slowed down to 8.3 percent in Q1. This is still high rate of growth if one compares it with the labor productivity growth in the same period of some 10 percent. However, the comparison is distorted by tax changes introduced by the new Personal Income Tax Law in January 2001, when lower marginal rate was reduced from 20 to 15 percent. Real growth of net wages was 3.4 percent in 2000 as compared to 10.1 percent in The growth of real net wages slowed down further in Q1 to 2.2 percent y-o-y. At the same time real pensions grew by 13.6 percent, mainly as a consequence of pensioners debt restitution. The replacement rate increased from 41 percent in December 2000 to 48 percent in February This one-off adjustment and the indexation formula will prevent in the medium-term any significant fall in this ratio. Average gross wage oscillated around 5000 HRK or some 610 USD in 2000, while remained at almost the same level thereafter. Compared to 1999, when gross wages grew by 10.2 percent, the rate of growth fell to 7 percent in Reduction of the pension and health contribution rates in mid-2000 caused the cumulative growth rate of average gross wage in economy to fall down to 3.8 percent. Wage growth after several years have registered a structural change as well. When looking at the sectoral division of the economy (NCEA classification), the highest increase in average net wage over the first three months was recorded in fishing (22.9 percent nominally and 16 percent in real terms), mining and quarrying (18.6 and 12 percent) and manufacturing industry (14 percent nominally and 7.7 percent in real terms). On the other hand, the lowest growth/decline was recorded in agriculture (-3.3 percent in nominal and 8.7 percent in real terms), electricity, gas and water supply (0.6 and 5.0) and public administration and defense (4.2 percent in nominal and 1.6 percent in real terms). The highest wages are still being paid in the air transport (63.4 percent above average), insurance and private pension funds (at 56.8 above average), banking sector (51.8 percent) and manufacturing of radio, TV and communication equipment (at 45.8 percent above the average). The share of workers receiving net wage below HRK 2,000 was 15.2 percent. At the same time the share of workers whose wage falls between HRK 3,000 5,000 stands at 52.1 percent. Number of workers below so called minimum contribution rate of 1,700 HRK was reduced to around 61 thousand people or 7.1 percent of total. Figure 7: Real Wages and Labor Productivity The productivity of Croatian industry (percentage change compared to the previous year) Productivity Net real average wage Figure 8: Public to Private Wages Ratio of Private to Public Sector Wage Growth (1992=100) by March Government made several attempts to control the consequences of the wage growth expansion in 1999 it reduced the state officials wages by approximately 20 percent and lowered the basic wage of civil servants by 5 percent. Restrictive wage policy was applied to a limited extent on public enterprises as well. The growth of public sector wages was contained in 2000 and the ratio of public to private wages in 2001 fell below 26 percent. In 2000, average public sector wage increased 9.2 percent, while business sector wages grew 8.7, all in nominal terms and in comparison with However, in the first quarter of 2001, average public sector wage grew by 6.4 percent, while private sector wage grew by 10 percent in nominal terms. In other words, private wage grew by 3.1 percent after corrected for inflation, while public sector wage fell by 0.3 percent.

6 WB Croatia Country Office Economic Highlights Croatia, June As agreed under Standby arrangement with the IMF, signed in March this year, Government has adopted a package of restrictive wage policy for 2001, which came into effect in June. It has been oriented towards restraining salary increases in public sector as well as in the public enterprises. As reflected in the Government program supported by the IMF, the Government s plans to achieve a 10 percent nominal reduction in the central government wage bill this year include both employment reductions and changes in the level and distribution of wages across the budgetary sector. FISCAL SECTOR Central Government (January May 2001) The revenue outturn for the first five months shows that the central budget collected HRK 16.7 billion kuna of revenues, or 5.3 percent less than in the same period last year. This is because the observed period last year recorded high capital revenues (privatization of Privredna banka). Opposite to this steep decline in capital revenues, current revenues recorded 8 percent higher collection than in the same period of This is thanks to strong increases in two most important single tax items; particularly VAT, which collected HRK 8.8 billion to the budget (a 12.2 percent increase), but also excises with HRK 2.9 billion (a 13.8 percent increase). The increase in revenue from excises is the result of higher collection of excises on oil products due to increased rate, and excises on imported motor vehicles, which have in the course of five months collected more revenues than in the whole 2000 (increased purchases due to announced abandoning of motor vehicle import duty exemptions for war veterans). As expected, changes in income tax legislation, as well as the lowering of customs rates and the signing of several free-trade agreements (with Slovenia, Macedonia, Hungary and Bosnia and Herzegovina) are resulting in lower tax collections. Income tax collections are 18.5 percent lower, while customs duty proceeds are 16.1 percent shorter than in the first five months of In May it was obvious that profit tax revenue was significantly underbudgeted, as the rate of growth by May was 13.1 percent higher than in Table 3: Outturn of Central Government Budget Central Government (millions of HRK) 2000 Outturn 2001 Plan I-V/01 Outturn I-V/01 I-V/00 Total revenue and grants 44, , , % As % of GDP* Current revenue 41, , , % Tax revenue 39, , , % Personal Income Tax 4, , , % Corporate Income Tax 1, , % VAT 21, , , % Excises 7, , , % Taxes on International Trade 3, , , % Nontax revenue 1, , % Capital revenue 3, , % Grants Total expenditure and net lending 50, , , % As % of GDP* Current expenditure 44, , , % Wages and contributions 15, , , % Other goods and services 8, , , % Interest payments 2, , , % Subsidies and transfers 17, , , % Capital expenditure 5, , , % Net lending 1, % Current account surplus/deficit -2, , ,731.4 As % of GDP* Overall deficit/surplus -6, ,044.8 As % of GDP* Stock of arrears 2,000.0 * GDP 2001 estimated by WB staff billion of kuna Source: Ministry of Finance Table 4: Outturn of Consolidated Central Government Consolidated Central I-V/ 01 As % of GDP* Plan Total Revenue and 66, , , Grants Budgetary Central Government 44, , , Extrabudgetary Funds 22, , , Pension Fund 11, , , Health Insurance Fund 8, , , Employment Fund Child Benefit Fund Public Water Management Fund 1, , Total Expenditure and 74, , , Net Lending Budgetary Central 36, , Government Extrabudgetary Funds 37, , Pension Fund 20, , Health Insurance Fund 13, , Employment Fund Child Benefit Fund 1, Public Water 1, Management Fund Overall Deficit/Surplus -7, , , Total Financing 7, , , Abroad 6, , , Domestic * GDP 2001 estimated by WB staff billion of kuna Source: Ministry of Finance On the expenditure side subsidies and transfers are displaying a rapid, much higher than planned increase. This is particularly true with transfers to other level of national government, in other words pension, health and child benefit funds, which only in the first five months were 2.2 billion higher than in the same period last year, totaling HRK 6.3 billion. Transfers to Bosnia and Herzegovina are halved compared to the first five months of

7 WB Croatia Country Office Economic Highlights Croatia, June Continuing practice of broad subsidizing of public enterprises resulted in 52.4 percent higher central budget subsidies. The Government s more restrictive wage policy has resulted in 2.6 percent lower total wage bill in the first five months of the year. The share of expenditure on wages and contributions in the total central government expenditure has gone down by 5 percent of total expenditure to 30.7 percent. Following last year s 40 percent slash, capital expenditures have continued falling in 2001, recording a 9.3 percent decrease in the observed period. Second rationalized expenditure item is central government purchases of other goods and services that were reduced by 5.2 percent y-o-y. Both figures, however, do not include any accumulated arrears. Higher foreign debt role in the central budget financing resulted in 33.7-percent increase in interest payments, amounting to HRK 1.5 billion. Consolidated Central Government (January May 2001) The first-quarter consolidated central government deficit reached HRK 3.3 billion. By May it broadened further to 3.9 bill HRK, or 2.3 percent of annualized GDP. The structural criterium for the Stand-By Agreement is a Consolidated Central Government deficit below 5.3 percent of GDP in While budgetary central government operations recorded HRK 3 billion surplus, it is the extrabudgetary funds that continuously expand the CCG deficit. Pension fund revenues have hardly covered half of its expenditures, generating a HRK 4.7 billion deficit, which is 36.2 percent more than in the same period last year, while additional HRK 1.1 billion of deficit was created by the health fund. As a result, the central government share in the overall consolidated central government expenditures has fallen down to below 46 percent. Budget Revision in June Although the 2001 central government budget envisaged a potential fiscal consolidation, at the moment it looks that this is going to be a very difficult fiscal year for the Government. The revised 2001 spending totals 58.1 billion kuna and revenues 55.3 billion kuna, leaving a central budget deficit equal to 1.63 percent of GDP. This includes the fall in privatization receipts by HRK 2 bill due to the low prospects for the IPO privatization of the Telecom during this year, and pension fund deficit of some HRK 800 mill. The Government plans to cover the deficit through additional foreign borrowing of 250 mill Euro and through new short-term domestic borrowing. However, fiscal developments in several sectors remain the main obstacle for accrual expenditure reduction during this year. Aware of this, the Government is planning another budget revision due to overspending on the wage bill, child benefits and pensions. On the expenditure side it means some HRK 2.3 bill higher expenses. While strong tourist season and positive trends in economy could bring about an increase in revenues collected, unparalleled compliance by tax payers will require additional expenditure reform measures. Additionally, although there are scarce options to raise additional revenues, a consolidation of the contributions collection mechanisms and broadening of the contribution tax base could partially lower the structural deficits in the pension and health funds, a measure being discussed for some time in the Government. MONETARY SECTOR Total bank lending expanded by HRK 4.7 billion in the period between the beginning of the year and May, of which HRK 2.2 billion accounts for corporate lending, which is a 8.6 percent increase, and HRK 2.4 billion for household lending (a 10.4 percent increase). Such a development is partly due to decreased interest rates both abroad and at home; domestic interest rates being still above offered interest rates abroad. Along with the banks preparations for the tourist season, the credit expansion has increased the demand for kuna, which, consequently, produced appreciation pressures on the kuna exchange rate (in the middle of May kuna was 4.5 percent stronger against DM/Euro than a year ago) earlier than seasonally usual. The central bank has intervened twice in the second part of April, purchasing Euro million, and two more times in May with additional purchases of Euro million. The money supply followed a seasonal pattern of growing in December (by as much as 10.0 percent), before decreasing in January (7.3 percent), and mildly increasing in February (1.5 percent). In April it stood at HRK 18.2 billion, which is 36.9 percent higher than in the same month of 2000, indicating that the CNB has in the course of last year radically shifted its long-running tight monetary policy. In line with this, the broadest money M4 aggregate continued its all-year long growth, reaching HRK 77.9 billion in April. Backed by Government s payments of its accumulated arrears, corporate demand deposits have been increasing throughout 2000, growing by 50 percent over the 12 month to HRK 7.1 billion in December. They, however, shrank in the first three months of this year by 9.6 percent and grew again after the Easter season. It remains to be seen whether this is only a temporary trend, or companies are beginning to lose their liquidity again. Unlike demand deposits, time and savings deposits, as well as foreign exchange deposits, continued growing

8 WB Croatia Country Office Economic Highlights Croatia, June steadily, showing that households, as main sector of depositors, are keeping their high confidence in banks. Only during the first four months of this year, the time and savings deposits increased by 16.3 percent (to HRK 8.9 billion), while the foreign exchange deposits grew by 6.7 percent (HRK 50.1 billion). The expansion of deposits was however stopped in April, probably due to the payments for car imports. CNB expects stronger growth of foreign exchange deposits in the Q4 this year due to the exchange of all European currencies in Euro. Namely, the commercial banks will do the exchange without any charge only for deposits held with these banks in New Monetary Policy Measures Although expected to be introduced somewhat later, the need to neutralize current appreciation pressures on the kuna exchange rate has urged the CNB management to come out with the new monetary policy measures, which are to be effective as of July 9. The measures include: (i) reduction of reserve requirement rate from 23.5 to 22.0 percent; (ii) extension of the base for calculating foreign currency reserve requirement to include the received foreign currency loans; and (iii) reduction of interest rate on statutory reserves from March s 3.7 to 3.5 percent. It is expected that the final results of the measures will be a net increase of the foreign currency share in the reserve requirement equivalent to around HRK 2.3 billion (meaning that the supply on the forex market will decrease), and a release of around HRK 320 million freed up from the kuna reserve requirement accounts. Figure 9: Domestic Credit and Deposits 75,000 70,000 65,000 60,000 55,000 50,000 45,000 40,000 35,000 30,000 Deposits Domestic credit Figure 10: Ratio of M4 to International Reserves Source: Croatian National Bank Source: Croatian National Bank International Reserves CNB s international reserves followed a seasonal pattern and decreased in January by USD million, before increasing over the next four months to reach USD 3.7 billion in May. April s and May s foreign exchange purchase, the intervention with a goal to slow down the appreciation of kuna, further increased the CNB s international reserves to the highest level ever. The current value of reserves represents a 19.1-percent increase when measured on an annual basis. The central bank has constantly been increasing the share of bonds and notes in the total international reserves at the expense of foreign currency and foreign currency deposits. Currently around two thirds of the reserves are held in the form of foreign currency or foreign currency deposits, and around 30 percent accounts for bonds and notes, while only a year and half ago the share of the latter was less than 13 percent. The growth of international reserves, and particularly the kuna value of the reserves, has not been following the strong increase of the M4 aggregate at the end of 2000 and the beginning of As a result, the M4 to international reserves ratio (ratio showing the central bank s ability to cover liabilities of the banking sector) went up from October s 2.33 to 2.60 in February, which is the highest value since mid-1999, before declining slightly in March to Strong Kuna Appreciation against DM/Euro February was the last month of five-month long kuna depreciation against DM/Euro, in which the DM/Euro period average exchange rate depreciated 2.3 percent to 3.94/7.70. The kuna appreciated very mildly in March, much stronger in April (with the end-of-month exchange rate standing at 3.85/7.53), and particularly strongly in May, appreciating to as low as 3.72/7.28 by the end of the month (which indicates a 5.6 percent nominal appreciation in comparison to the same date last year). Such a strong appreciation appeared before it is seasonally expected, and is the result of banks withdrawal of foreign assets and its conversion into kuna loans, as well as their

9 WB Croatia Country Office Economic Highlights Croatia, June preparation for the tourist season. Besides a strong foreign exchange inflow associated with the summer tourist season, it is expected that this fall s kick-off of a conversion of foreign exchange savings denominated in one of Euro zone currencies kept outside banks into Euro will produce further appreciation pressures. With regards to the US dollar, the period average exchange rate of kuna appreciated 4.4 percent in one month against the US dollar in January to 8.09, and depreciated again in February and March to It has been fluctuating in the range in April and May. In the first four months of 2001, the kuna nominally depreciated against the basket of five currencies with the highest share in foreign currency transactions by 0.5 percent. Deflated by producers prices, the real kuna depreciation rate against the basket of currencies in the first two months of the year is 0.23 percent, while depreciation rate is slightly higher (0.6 percent) when CPI is used as a deflator. Exchange rate has stabilized. The appreciation of Croatian kuna has been stabilized at the end of May stopping DM at some 3.72 kuna. The Central Bank intervened by broadening of the obligatory reserve requirement to foreign currency loans with the rate of 11 percent. Current two rates 23.5 and 11 percent will be unified in July at the level of 22 percent. The latest change in reserve rules freed some 320 mill kuna in commercial banks and eased demand for kuna. Foreign exchange supply in the market shrank, while the kuna liquidity is sufficient for a continued credit activity of the banks to support an economic revival without causing undesirable inflationary pressure. Interest Rates Still Falling Continued high liquidity of the banking system is reflected in the ongoing downward trend in interest rates. Average money market interest rate, which was cut by almost two thirds in 2000, fell to only 3.81 percent in January. February recorded a slight increase due to initial inconveniences associated with the introduction of the National Clearing System, but the rate fell again to 3.61 percent in March. A cut in the money market interest rate on overnight transactions in 2000 was even stronger, starting the year at 10.0 percent, while ending at 2.39 percent. In January it recorded a further mild decrease before increasing to 3.31 percent in February and falling down in March to April s data show the increase again to 5.04 percent indicating some liquidity problems related to the annual payments of the profit tax for the last year. In an attempt to enhance the development of the secondary market, the central bank has reduced the frequency of auctions of its bills (which are now held every 35 days) as well as their maturity (from 35, 91 and 182 to 35, 70 and 105 days). As a result, it seems that banks have shifted its surplus liquidity from CNB bills (which are bearing higher yield) to T-bills issued by the Ministry of Finance. In April, interest rates on CNB kuna bills on voluntary basis maturing in 35 and 70 days went down to 6.36 and 6.73 percent respectively, while the total stock declined from January s HRK 2.6 billion to HRK 2.5 billion in April. Although the stock of CNB bills on voluntary basis denominated in foreign currency increased 16.9 percent in February comparing to January, the total stock of CNB bills on voluntary basis of HRK 4.2 billion in February was HRK 0.3 billion lower than the month before. March somehow improved the picture, with the stock of CNB kuna bills enlarging to HRK 2.6 billion, and the total stock of bills on voluntary basis going up to HRK 4.5 billion. End of March recorded additional cuts in interest rates on T-bills; interest rate on 42-day bills fell down to 5.95 (from 11.0 percent only twelve months ago), 91-day bills to 7.0 percent, and 181-day bills to 7.3 percent. This has, however, not discouraged investors (88 percent of which in March were banks) to invest more of their excess liquidity into these securities, the stock of which has soared 79.7 percent from the beginning of the year until the first part of May to reach HRK 4.4 billion. CAPITAL MARKET January June 2001 Since it started recovering at the beginning of the year, CROBEX Stock Market Index gained 15.6 percent by early March, when it broke a 1000 point boundary, just after the signing of the IMF Stand-By Agreement. CROBEX index was above 1000 points last time in April 1998, the time of the growth peak before the. Throughout the rest of the month, as well as April and June it has been oscilating in the range. Share turnover was halved in January to HRK 53.9 million, of which 40 percent accounted for Pliva shares. As the total share turnover was increasing in the next two months (23 percent in February and an additional 14 percent in March), so was the share of Zagrebacka banka share in total turnover, which reached 51 percent in March. After a long period of speculations, in May this bank publicly announced the proposed plan of its takeover by strategic partners, Italian UniCredito (to hold a 60 percent stake) and German Allianz (15 percent). The official offer was withdrawn one month later. April saw a slowdown in share turnover, which declined 30.2 percent comparing to March.

10 WB Croatia Country Office Economic Highlights Croatia, June Newly activated bond market, which kept very quite in January and February, was revitalized by the listing of Bank Rehabilitation Agency (BRA) bonds in mid-march, which, along with a higher trade of CHII bonds, increased the March bond turnover sixteen times to HRK 78.6 million. Already in April the bond turnover more than halved to HRK 31.2 million. On-line auctions of shares from the portfolio of the Croatian Privatization Fund have up to now sold shares of more than 200 companies in which the CPF held less than 25 percent of ownership, with the total turnover of more than HRK 22 million. Figure 11: CROBEX Stock Market Index, (12/1997=100) Russian Crisis Announcement of New Elections IMF agreement Figure 12: International Bond Traded Spread, bps International B ond Traded S pr e a d Source: Zagreb Stock Exchange Source: Zagreb Stock Exchange On March 5, 2001, Deutche Bank and JP Morgan lead managed the Euro-denominated Government bonds. Bonds were issued with 215 bps spread over 10-year German government bonds and annual coupon of 6.75 percent. Spread fell further in April and May close to 150 bps. Aware that budgeted revenues from privatization will not be met during this year, such a historical low spread was the reason for the Government to tackle the international capital market again in early July for Euro 250 mill. EXTERNAL SECTOR Increased Imports Broadened the Trade Deficit in the First Five Months of 2001 The first five months were characterized by sharp increase in imports of goods, and a very modest one in exports, resulting in a much higher trade deficit than in the same period of The provisional data show that imports of goods in USD increased by 26.6 percent, while exports grew only slightly by 1.4 percent, causing 67.4 percent higher January May deficit than in the same period last year, totaling at USD 1.85 billion. This had an impact on the coverage of imports by exports in the observed period, which deteriorated to 49.5 (61.8 percent in the same period last year). According to SITC classification, imports recorded such a strong growth mainly due to increases in imports of machinery and transport equipment and manufactured goods classified by material (leather, textile, iron, steel, metals, etc.). Within the two categories, the most important increases were recorded in imports of textile products, iron and steel, computers, industrial machinery and equipment and road vehicles (69.7 percent). Exports, on the other side, grew the most in the categories of beverages and tobacco and manufactured goods classified by material, particularly of non-metallic mineral products, metals and non-ferrous metals and iron and steel. Exports would have grown at faster pace had there not been an underperformance in the exports of chemicals (18.2 percent down) and machinery and equipment (10.5 percent). Following a successful year, in which exports to EU countries grew 14.5 percent, the trend reversed in the first five months of 2001, recording 1.7 percent decline in comparison with the first five months of Since, at the same time, imports from these countries rose 26.7 percent, the trade deficit with EU almost doubled in comparison with the same period last year to USD 1.04 billion. Although imports from EU increased, the share of imports from EU in the overall imports retained the previous levels of around 55 percent, while the share of exports to EU in the overall exports mildly increased to also around 55 percent. Croatian Government concluded the SAA agreement with the EU in May. Parts of the SAA referring to the economy and liberalization of trade would come into force from January The EU opened its market for

11 WB Croatia Country Office Economic Highlights Croatia, June Croatian products last November, while Croatia will open its market for EU products after the official signing of SAA. A zero custom rate will be introduced for some industrial products at once, whereas other, more sensitive industrial goods will be liberalized over a 2-6-year period during which tariffs decrease gradually. Balance of Payments (January December 2000) Preliminary fourth-quarter balance of payments data show that the country managed to narrow down its current account deficit by two thirds in the course of just one year. Moreover, the preliminary USD million current account deficit, or 2.8 percent of GDP, is the lowest deficit ever since the current balance turned negative in Almost a billion USD lower deficit in current account in 2000 is mainly a result of USD million higher surplus in services account (38.9 percent increase), and USD million surge in the surplus of the net current transfers (51.7 percent growth). Within the services account surplus, 25.7 percent higher net foreign currency inflow was recorded in tourism, of which a significant 40.2 percent goes to lower foreign currency outflows resulting from tourism expenditures abroad (USD million lower than in 1999), while the rest is attributed to USD million higher foreign consumption of Croatian tourist services (10.6 percent increase), which totaled at USD 2.8 billion. Another important single-item change can be seen in USD million lower Government transfers abroad (56.5 percent cut), which is explained by significant reduction in Government s transfers to Bosnia and Herzegovina. Net private transfers increased 20.3 percent, reaching USD million. Following a three-year long deficit growth, the income account recorded an 11.4 percent lower deficit (totaling at USD million), although net outflow from direct and portfolio investment income increased 55.7 percent. While services, income and current transfer accounts recorded significant improvements both in nominal and relative terms, goods account balance improved only slightly. The goods account deficit decreased by only 1.9 percent in comparison to 1999, recording a deficit of USD 3.2 billion. While both exports and imports of goods have increased, the declining deficit is a result of stronger increase of exports (3.9 percent) than of imports (1.4 percent). Although a financial account (excluding reserves) recorded a 52.4 percent lower surplus than in 1999 (total of USD million), it was more than sufficient to cover the deficit accumulated on the current account. Decrease in financial account surplus is attributed to 42.7 percent lower inflows from net foreign investment (total of USD million), and was partly offset by 27.6 percent increase in portfolio investments. International reserves of the Croatian National Bank increased USD million in 2000, or 35.8 percent in relative terms. Table 5: Balance of Payments (Millions of USD) * 2000 * / 1999 CURRENT ACCOUNT % Goods % - Exports 4, % - Imports % Services % - Credit % - Debit % Income % Current transfers % CAPITAL AND FINANCIAL % ACCOUNT Capital account % Financial account, excluding % reserves Direct investment % Abroad % In Croatia % Portfolio investment % Other investment % Reserve Assets % NET ERRORS AND OMISSIONS % *(Preliminary data) Source: Croatian National Bank Figure 13: Short-Term Debt, % Of Total Short term external debt as percentage of total IV 2001 Source: Croatian National Bank Table 6: Debt Indicators (%) (IV) Short-term debt/ Total external debt External debt/gdp Debt Service/ Exports of GNFS Source: Croatian National Bank

12 WB Croatia Country Office Economic Highlights Croatia, June If the same trend of non-car imports continues during the second half of the year, trade deficit could hit USD 4.6 billion in With the exports of services growing at the rate of some 13 percent, current account deficit could reach 5.1 percent of GDP, 0.6 percent more than assumed in the Stand-By program. As it is not likely that the credit expansion will slow down in the second half of the year, the expectation of some 15 percent higher import growth seems quite realistic. As most of the deficit will be attributable to the one-off effect of tax-exempted car imports, the very next year will bring the deficit back to around 3 percent level, which is considered as the structural deficit of this economy. Rapidly Growing Share of External Debt in GDP At the end of 2000, the total external debt stood at USD 10.9 billion, which is 10.2 percent higher than at the end of last year. External debt reached 57.2 percent of GDP in December. Although such a steep increase in terms of GDP is partly the result of lower USD value of estimated Croatian GDP due to kuna depreciation against the US dollar, the fact is that the total external debt of the country gained another USD 1.0 billion last year, of which USD 0.8 billion accounts for the net increase in public sector s external debt (USD 4.8 billion at the end of the year). First four months showed another increase in external debt, recording an additional USD 460 million increase, totaling at USD 11.3 billion. Banks more than doubled their short-term external debt in the last quarter of 2000, and, as a consequence, the share of a short-term external debt in the total external debt rose to 7.5 percent in December and 7.6 in March. Slightly lower debt service (3.2 percent), and increased exports of goods, and particularly, services (altogether 6.6 percent higher than in 1999), produced a lower debt service to exports of goods and non-financial services ratio in 2000, which fell from 1999 s 21.5 to 20.4 in 2000.