document of the world bank · 2016. 7. 17. · document of . the world bank . for official use only...
TRANSCRIPT
Document of The World Bank
FOR OFFICIAL USE ONLY
Report No. 58226-HR
INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT
PROGRAM DOCUMENT
FOR AN ECONOMIC RECOVERY DEVELOPMENT POLICY LOAN
IN THE AMOUNT OF EUR150 MILLION
(US$213 MILLION EQUIVALENT)
TO
CROATIA
April 4, 2011
Poverty Reduction and Economic Management Central Europe and the Baltics Country Unit Europe and Central Asia Region
This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
Croatia - Government Fiscal Year January 1 – December, 31
CURRENCY EQUIVALENTS (Exchange Rate Effective as of April 4, 2011)
US$1.00 HRK5.216
WEIGHTS AND MEASURES Metric System
ABBREVIATION AND ACRONYMS
CFAA Country Financial Accountability Assessment HWVs Homeland War Veterans
CEB Council of Europe Development Bank IBRD International Bank for
Reconstruction and Development
CGG Consolidated General Government ICR Implementation Completion and Results Report
CNB Croatian National Bank IMF International Monetary Fund
CPAR Country Procurement Assessment Report INTOSAI International Organization of
Supreme Audit Institutions CPS Country Partnership Strategy CPF Croatian Privatization Fund LFS Labor Force Survey
CROSTAT Croatian Statistical Bureau MEPPPC Ministry of Environmental Protection, Physical Planning and Construction
DPL Development Policy Loan MoELE Ministry of Economy, Labor and Entrepreneurship
DPPS Department for Public Procurement System MoF Ministry of Finance
EBRD European Bank For Reconstruction and Development MoHSW Ministry of Health and Social
Welfare EC European Commission MP Member of the Parliament EIA Environmental Impact Assessment NATO North Atlantic Treaty Organization
EIB European Investment Bank OECD Organization for Economic Development and Cooperation
ERP Economic Recovery Program PAL Programmatic Adjustment Loan
ERDPL Economic Recovery Development Policy Loan PAYG Pay As You Go
ESA European System of National and Regional Accounts PFR Public Finance Review
EU European Union PFM Public Finance Management EUROSTAT European Statistics PIT Personal Income Tax FDI Foreign Direct Investment PPP Public Private Partnership FIA Financial Impact assessment R&D Research and Development FINA Croatian Financial Agency SHI Supplemental Health Insurance
FMIS Financial management and Information System SAO State Audit Office
FRL Fiscal Responsibility Law SME Small and Medium Enterprises FX Foreign Exchange SOE State Owned Enterprises GDP Gross Domestic Product SEA Strategic Environmental Assessment
HBS Household Budget Survey SEVESO II
EEC Directive on the major-accident hazards of certain industrial activities
HRK Croatian Kuna SIGMA Support for Improvement in Governance and Management
HRMIS Human Resources Information SWDP Social Welfare Development Project
ii
Management System
HZZO Croatian Institute for Health Insurance TSA Treasury Single Account
Vice President: Country Director:
Sector Manager: Task Team Leader:
Philippe H. Le Houerou Peter C. Harrold Satu K. Kahkonen Sanja Madzarevic-Sujster
CROATIA
ECONOMIC RECOVERY DEVELOPMENT POLICY LOAN (ERDPL)
TABLE OF CONTENTS
LOAN AND PROGRAM SUMMARY 1 I. INTRODUCTION 3 II. COUNTRY CONTEXT 3
A. RECENT ECONOMIC DEVELOPMENTS IN CROATIA ...................................................... 4 B. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ......................................... 8
III. THE GOVERNMENT’S PROGRAM AND PARTICIPATORY PROCESSES 13 A. ENHANCING FISCAL SUSTAINABILITY THROUGH EXPENDITURE-BASED CONSOLIDATION ................................................................................................................... 15 B. FOSTERING PRIVATE-SECTOR GROWTH ...................................................................... 22 C. CONSULTATION AND PARTICIPATION .......................................................................... 27
IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM 28 A. LINK TO CPS ............................................................................................................... 28 B. COLLABORATION WITH THE IMF AND THE EU .......................................................... 28 C. RELATIONSHIP TO OTHER BANK OPERATIONS ............................................................ 29 D. LESSONS LEARNED ...................................................................................................... 30 E. ANALYTICAL UNDERPINNINGS .................................................................................... 30
V. THE PROPOSED ECONOMIC RECOVERY DEVELOPMENT POLICY LOAN (ERDPL) 31 A. OPERATION DESCRIPTION ........................................................................................... 31 B. POLICY AREAS ............................................................................................................ 33
VI. OPERATION IMPLEMENTATION 35 A. POVERTY AND SOCIAL IMPACT ................................................................................... 35 B. ENVIRONMENTAL ASPECTS ......................................................................................... 37 C. IMPLEMENTATION, MONITORING AND EVALUATION .................................................. 38 D. FIDUCIARY ASPECTS ................................................................................................... 39 E. DISBURSEMENT AND AUDITING .................................................................................. 40 F. RISKS AND RISK MITIGATION ..................................................................................... 41
TABLES Table 1: Croatia - Key Macroeconomic Indicators (percent of GDP) ................................................ 5Table 2: Selected Financial Sector Soundness Indicators ................................................................... 7Table 3: Croatia - Macroeconomic Projections (percent of GDP) ...................................................... 9Table 4: Fiscal Consolidation Plans, percent of GDP ....................................................................... 11Table 5: External Financing and Exposure Indicators, 2007-2013 ................................................... 12Table 6: Summary of the Proposed Reform Program and the ERDPL1 Actions .............................. 32Table 7: Consumption Poverty in Croatia, 2008 -2011 ..................................................................... 35Table 8: Impact of Selected Policy Reforms on Poverty .................................................................. 36 FIGURES Figure 1: Croatia: Crisis Impact and Recent Economic Developments, 2004-2010 ........................... 6Figure 2: General Government Balance, percent of GDP ................................................................. 10Figure 3: Public Debt Sustainability ................................................................................................. 13Figure 4: External Debt Sustainability .............................................................................................. 13Figure 5: Business Environment in Croatia and its Regional Peers, 2010 ........................................ 24Figure 6: Projected Change in Net Disposable Household Income in 2011, in real terms ............... 37Figure 7: Projected Poverty by Household Head's Status of Employment ....................................... 37 BOXES Box 1: Financial Sector Stress Test Results ........................................................................................ 8Box 2: Croatia’s Economic Recovery Program ................................................................................ 14
2
ANNEXES Annex 1: Letter of Development Policy ............................................................................................ 42Annex 2: Croatia ERDPL Policy Matrix ........................................................................................... 47Annex 3: Fund Assessment Note ...................................................................................................... 50Annex 4: Country Map IBRD 33394 ................................................................................................ 55
1
LOAN AND PROGRAM SUMMARY
CROATIA
ECONOMIC RECOVERY DEVELOPMENT POLICY LOAN (ERDPL)
Borrower
The Republic of Croatia
Implementing Agency
MINISTRY OF FINANCE
Financing Data
IBRD Flexible Loan amounting to EUR150 million (US$213 million equivalent) at 6 month EURIBOR for EUR plus fixed spread with a 15-year bullet repayment pattern
Operation Type First in a series of two single-tranche Development Policy Loans (DPL)
Main Policy Areas Public Sector, Social Protection, and Private Sector Development Key Outcome Indicators
• General Government spending reduced from 43.2 percent of GDP in 2010 to 40.9 percent of GDP in 2012;
• General Government wage bill reduced from 10.7 percent of GDP in 2010 to 9.9 percent of GDP in 2012;
• Total public health spending reduced from 6.9 percent of GDP in 2010 to 6.2 percent of GDP in 2012;
• Social benefit spending reduced from 2.6 percent of GDP in 2010 to 2.3 percent of GDP in 2012;
• Pension spending reduced from 10.5 percent of GDP in 2010 to 9.7 percent of GDP in 2012;
• Labor force participation rate (15-64) increased from 62.4 percent in 2009 to 64 percent in 2012;
• Institutions score (from Global Competitiveness Index) increased from 3.6 in 2010-2011 to 3.9 in 2012;
• Private sector share in GDP increased from 70 percent in 2009 to 75 percent in 2012;
• Research and development spending increased from 0.8 percent of GDP in 2009 to 1.1 percent in 2012.
Program Development Objective(s) and Contribution to CAS
The objective of the ERDPL series is to support economic recovery through: (i) enhanced fiscal sustainability through expenditure-based consolidation; and (ii) fostered private sector growth. The proposed ERDPL supports three goals of the CPS that aim to sustain macroeconomic stability, strengthen private-sector led growth and improve efficiency of social sectors.
Risks and Risk Mitigation
The proposed ERDPL series has very high risks. The key risks are as follows:
Economic risks. Economic risks are substantial given Croatia’s prolonged recession and high external vulnerability. The key risk is
2
that economic recovery in the EU and Croatia may be weaker than currently projected. Slower than projected growth in Croatia would further strain the fiscal stance, the corporate sector and consequently the banks, and could raise social tensions. Croatia’s heavy reliance on tourism revenues and exports to Europe makes it vulnerable to any deterioration in regional stability or slowdown of growth in the EU. Given the uncertain economic situation in some EU countries and volatility resulting from fears of contagion, the planned fiscal consolidation will be harder than previously thought. This could jeopardize the achievement of planned medium-term macroeconomic and social outcomes. Furthermore, the high level of external debt, the high degree of euroization of the Croatian economy and large debt service requirements over the medium term render the Croatian financial sector vulnerable to exchange rate risks and a slowdown in capital inflows. Refinancing of external obligations may thus become challenging. Mitigation measures. The ERDPL-supported fiscal consolidation efforts are expected to mitigate the risks related to regular public debt servicing even in the case of a prolonged recession. In parallel, reforms supporting the private sector growth are expected to accelerate recovery in Croatia. The ERDPL team will continue to monitor financial sector performance.
Political risks. Political risks remain high. The country has a coalition Government with a slim majority in Parliament, while several proposed reforms are ambitious and politically challenging. The need to mitigate the impacts of recession and implement a fairly broad medium-term reform agenda in a difficult economic environment might strain the coalition, with an uncertain impact on the reform agenda. With general elections tentatively scheduled for late 2011, the country is entering a pre-election period which may raise the risk of unsound policies. High unemployment and increasing pressures from various social groups may reduce the already low social appetite for reforms, including for the labor market reform. Mitigation measures. Most reforms proposed to be supported under the ERDPL are being implemented. Some are also part of EU accession negotiations, which is expected to mitigate the risk of reversal or delays. Given the recently announced timetable for the conclusion of EU accession negotiations by mid-2011, the momentum for reform is likely to be maintained.
Operation ID PE-P122221 Map IBRD 33394
The Croatia Economic Recovery Development Policy Loan was prepared by a team consisting of Sanja Madzarevic-Sujster (Task Team Leader), Emilia Skrok, Matija Laco (ECSP2), Kari Hurt (ECSH1), Jan Rutkowski, Zoran Anusic, Ivan Drabek (ECSH3), Amitabha Mukherjee (ECSP4), Natasa Vetma (ECSS3), Lamija Marijanovic (ECSC3), Antonia Viyachka (ECSC2), Dubravka Jerman (ECCHR), Danijel Nestic (Consultant). The team benefited from the guidance of Satu Kahkonen (ECSPE).
3
IBRD PROGRAM DOCUMENT FOR A PROPOSED ECONOMIC RECOVERY DEVELOPMENT POLICY LOAN (ERDPL)
TO CROATIA
I. INTRODUCTION
1. The proposed Economic Recovery Development Policy Loan (ERDPL) to the Republic of Croatia in an amount of EUR150 million (US$213 million equivalent) supports Government's efforts to accelerate sustainable economic recovery. The global financial crisis has severely affected the Croatian economy, with GDP contracting over 7 percent from the crisis outbreak to end-2010. With high external debt and significant balance sheet exposure to the exchange rate risk, market confidence in Croatia has deteriorated sharply, but the Government has acted fast to address these vulnerabilities. The reform program proposed to be supported by the ERDPL has been developed jointly with the Government, and builds upon the Government’s Economic Recovery Program. The ERDPL objective is to support recovery through measures that: (i) promote fiscal sustainability through expenditure-based consolidation; and (ii) foster the private sector growth. The proposed ERDPL series is also intended to mitigate the fiscal risks that might occur if the recovery gets more delayed than expected.
2. The proposed reform program reflects lessons learned, findings and recommendations of a range of recent and ongoing lending, as well as analytical and advisory services. The analytical work the program builds on includes a Public Finance Review, the Social Impact of the Crisis and Building Resilience Report, the Public Sector Governance Assessment, and policy notes on fiscal responsibility frameworks, pension and labor issues. On the lending side, the program draws on the Social Welfare Development Project, the Development of Emergency Medical Services and Investment Planning Project which supports development of the hospital master plan, and the Justice Sector Support Project. The program has been coordinated with other development partners, and in particular with the European Commission (EC) to ensure consistency with the EU accession requirements and the IMF.
3. The choice of a series of two single-tranche operations reflects the medium-term nature of reforms proposed to be supported and the specific political environment in which the proposed ERDPL will be implemented, with general elections set for late 2011. The lessons learned from prior development policy lending as described in the FY09-12 Country Partnership Strategy have also affected the choice of instrument. In addition to the ERDPL series, the Bank will support the broader medium-term competitiveness and growth agenda through analytical work and other complementary lending operations, including a financial intermediation loan and investment operations in infrastructure, science and technology, and the justice sector.
II. COUNTRY CONTEXT
4. The coalition Government, led by the Croatian Democratic Union (HDZ) party, was endorsed by the Croatian Parliament in 2008 and then reconfirmed under Prime Minister Kosor in July 2009. The Government strategy described in the Program of the Government of the Republic of Croatia for 2009-2011 emphasizes reforms which promote macroeconomic stability as the basis for accelerated recovery in the post-crisis period. To sustain macroeconomic stability and promote growth recovery, the Government, among other things, aims to: (i) accelerate judicial and public administration reforms, (ii) complete the privatization process and tackle corruption, (iii) intensify development of SMEs and increase agricultural competitiveness while pursuing balanced regional development, (iv) foster tourism with further development of infrastructure, and (v) promote a
4
knowledge-based society. Government measures to secure macro stability through cuts in social benefits and wages as well as a rise in taxes during 2009 and 2010 prompted calls for early elections by various social groups. However, despite these politically difficult decisions and economic hardship, social peace appears to have been maintained and economic reforms have continued.
5. Croatia became a NATO member in April 2009 and its EU accession prospects have strengthened. There has been continued progress in adopting the EU acquis communautaire. To date, Croatia has closed 28 out of 35 negotiations chapters with the EC, and expects to close all of them by mid-2011. According to the 2010 EU Progress Report, Croatia continues to meet the political criteria and has made progress in most areas, including intensified efforts on the rule of law. However, it also indicated that the Government will need to step up reforms on judiciary and fundamental rights, in particular regarding the independence and efficiency of the judiciary, the fight against corruption and organized crime, competition policy and effective public administration. Croatia aims to accede to the EU by end-2012.
A. RECENT ECONOMIC DEVELOPMENTS IN CROATIA Pre-crisis and crisis
6. Croatia enjoyed strong economic growth of around four percent annually before the global crisis, driven by the boom in private investment and consumption fuelled in part by large capital inflows. Although exports grew significantly (led by oil, agriculture and ships), import growth (led by capital goods and oil) was much stronger, which, coupled with the terms of trade deterioration, led to widening of the current account deficit to nine percent of GDP by 2008. Since only half of the current account deficit was financed through non-debt creating inflows, external borrowing increased and the external debt to GDP ratio reached 80 percent.
7. The global crisis affected severely the Croatian economy. Real GDP shrank by almost six percent in 2009, driven by large drops in investment and private consumption. With high external debt and significant balance sheet exposures to interest and exchange rate risks, underpinned by global investors’ risk aversion, market confidence in Croatia deteriorated sharply. Delayed privatization and restructuring of state-owned companies, an investment climate insufficiently supportive of green-field investments and pro-cyclical fiscal spending added to structural problems.
8. As the crisis unfolded, public finances came under substantial strain. Due to declining tax revenues, fiscal policy had to undergo significant adjustments to protect macroeconomic stability and ensure regular debt service. Politically challenging measures on both revenue and spending sides had to be implemented, while protecting the effective part of the social safety net. These measures included a reduction in public sector wages, suspension of pension indexation and the introduction of a solidarity tax. Nevertheless, the headline general government deficit widened from 0.9 percent of GDP in 2008 to 4.6 percent of GDP in 20101
9. At the same time, immediate policy response supported financial stability. During 2009 and early 2010, the Croatian National Bank (CNB) addressed liquidity shortages in the banking sector through relaxation of regulatory requirements and repo auctions, while intermittent foreign exchange interventions alleviated depreciation pressures on the local currency. Banks weathered the crisis relatively well due to adequate capitalization, although the credit quality worsened significantly and profitability declined, largely reflecting an increase in the provisioning for non-performing loans. Building on long-standing efforts in this area, the authorities also took necessary measures to safeguard financial intermediation, through important enhancement of the financial sector legislative framework, also recognized by the World Bank Fiscal, Social and Financial Sector DPL.
.
1 The adjusted fiscal balance that includes pensioners’ debt, called shipyards’ guarantees and Croatian Highways rose from 2.5 percent of GDP in 2008 to 5.4 percent of GDP in 2010.
5
Table 1: Croatia - Key Macroeconomic Indicators (percent of GDP)
Note: USD terms derived. Fiscal Balance includes consolidated general government adjusted for the pensioners’ debt repayment and Croatian Highways based on GFS86 methodology. For comparison, headline general government deficit based on the national methodology amounts to 4.6 percent of GDP in 2010. Source: CROSTAT, CNB, MoF, staff estimates
Aftermath of the Crisis
10. Government efforts succeeded in alleviating, but not offsetting, the impact of the global crisis. While the recession started easing in the last quarter of 2009, the output contracted further by 1.2 percent in 2010. Tourism and retail trade temporarily recovered during the summer months, but were inadequate to end the crisis. With the recovery of main EU markets, net exports have remained the key growth factor, while the domestic demand dropped further due to a decline in disposable income.
11. Significant external adjustment has taken place over the last two years. The current account deficit nearly halved to around five percent of GDP in 2009, backed by a fall in imports by more than one-third. It continued narrowing towards three percent of GDP by September 2010, with exports of goods recovering as major export markets improved and net capital inflows receded. International reserves rebounded to EUR10.7 billion (8.5 months of imports equivalent) at end-2010.
EstimateIndicators 2007 2008 2009 2010
National Accounts Real GDP growth 5.1% 2.2% -6.0% -1.2% Total Investment 29.4 30.7 27.1 23.4 Gross National Savings 22.1 21.2 21.5 21.5 Foreign Savings 7.5 8.9 5.2 2.0
Public Sector Primary Balance 0.0 -0.8 -3.1 -3.2Interest payments 1.8 1.7 2.0 2.2Fiscal Balance -1.8 -2.5 -5.0 -5.4
Balance of PaymentsTrade Balance -21.8 -22.8 -16.2 -13.9Current Account Balance -7.5 -8.9 -5.2 -2.0FDI 7.9 6.7 2.6 2.0
DebtForeign Debt 81.6 79.5 97.6 99.8Public Debt (incl. gov't guarantees) 41.5 42.0 50.2 57.9
Gross Internat. Res. (in months of Imports G&NFS) 5.6 4.4 7.2 6.9Memo items:GDP (US$ millions) 59,319 69,920 63,435 60,830Inflation (p.a., %) 2.9 6.1 2.4 1.1Debt service to export ratio 36.1 27.8 45.9 37.7Exchange rate HRK:US$ (p.a.) 5.37 4.93 5.28 5.50
Actual
6
The external debt continued to increase, but at a noticeably slower rate, to EUR45.7 billion or equivalent to around 99 percent of GDP by December 20102
Figure 1: Croatia: Crisis Impact and Recent Economic Developments, 2004-2010
.
Croatia’s recovery is more delayed than expected… … further extending pressures on public finances.
External adjustment continued as capital inflows abated…
…leading to stabilization of external debt.
Source: CNB, MoF, CROSTAT, staff calculations
12. The fiscal balance deteriorated further in 2010 and continues to be under substantial pressure owing to delayed recovery. The 2010 budget revision in August 2010 called for a headline consolidated general government deficit of 4.6 percent GDP3 and reflected a revenue short-fall. In response, several benefits were reduced, including privileged pensions and supplementary health insurance benefits paid from the budget. Numerous tax exemptions were abolished. The Government also committed to freezing nominal consolidated central government spending in 2011-2012 at the 2010 level. However, to alleviate the impact on living standards, the special crisis tax was lifted ahead of the statutory deadline and personal income tax rates were lowered4
2 Investments made in an enterprise through a legal person set up in third country (in this case Croatia) solely for this purpose.
. In 2010, government borrowing requirements surged by 40 percent to 12 percent of GDP to cover refinancing costs and the fiscal deficit.
3 Based on the national fiscal methodology. According to GFS 1986, Consolidated General Government deficit would amount to 5 percent of GDP, and after inclusion of off-budget items (Croatian Highways and pensioners’ debt repayment) it would reach 5.4 percent of GDP. 4 There were four marginal personal income tax rates (15, 25, 35 and 45 percent); after July 2010, there are three rates (12, 25 and 40 percent) with the non-taxable income unchanged at HRK1,800.
-10
-8
-6
-4
-2
0
2
4
6
8
2004 2005 2006 2007 2008 2009 2010e
Domestic demand
Real GDP
in %
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0-7.0
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
2004 2005 2006 2007 2008 2009 2010e
Public debt (rhs)Fiscal balance (lhs)
-4
-2
0
2
4
6
8
Q1
2007
Q2
2007
Q3
2007
Q4
2007
Q1
2008
Q2
2008
Q3
2008
Q4
2008
Q1
2009
Q2
2009
Q3
2009
Q4
2009
Q1
2010
Q2
2010
in b
n E
UR
Reserve assets Direct investmentPortfolio investment Other investmentCapital and Financial account
20
30
40
50
60
70
80
90
100
0
5
10
15
20
25
30
35
40
45
50
2004 2005 2006 2007 2008 2009 2010e
in %
of G
DP
in E
UR b
nin EUR bnin% of GDP
7
13. Despite these developments, the access to finance was preserved. Strong liquidity in the financial sector allowed the Government to raise domestically approximately EUR2.7 billion in bonds and loans in 2010. In addition, in July 2010, the Government issued USD1.25 billion in bonds in international capital markets. As a result, public debt with government guarantees reached 58 percent of GDP by the end of 2010. In late 2010, the S&P credit rating agency reduced Croatia’s sovereign credit rating by a notch to BBB- with a negative outlook emphasizing country’s deteriorating fiscal position and weak external funding flexibility. Subsequently, in March 2011, the Government renewed the bond issue at the US market for USD1.5 billion at a 10-year maturity with the spread 350 bps over the benchmark.
14. Monetary policy continued to support stable currency. The monetary policy framework has anchored inflation expectations and reduced exchange rate-related credit risks in a highly-euroized environment. During 2009 and early 2010, the central bank abolished administrative measures implemented in the pre-crisis period, lowered the reserve requirement (currently still at a high 13 percent) and increased the kuna share in obligatory reserves, thereby releasing liquidity equivalent to 8.5 percent of GDP and preventing pressures on local currency depreciation. Ample liquidity, accompanied by government-supported credit schemes5
15. The financial sector continues to be affected by the prolonged recession. Non-performing loans (NPL) continued rising to 11 percent by end 2010, partially driven by tightened prudential regulations. Provisioning for NPLs account for half of the net operating income of the entire banking sector (
, supported credit activity in early 2010. However, the private sector deleveraging continued due to the weak recovery of domestic demand. Combined with a risk-averse banking sector, the private sector credit growth remained subdued (rising by only 3.6 percent in 2010 excluding exchange rate movements).
Box 1) and is driving a decline in profitability of the sector. Uncertainties remain about the level of potential losses hidden in banks' balance sheets, in particular in construction and real estate industries. However, capital adequacy remained strong – at 18.5 percent at end-2010 after the adjustment to Basel II-- and the liquidity remained strong in particular after the Central Bank decision in February 2011 to reduce the asset to liability ratio for foreign currency from 20 to 17 percent, and thus release additional EUR850 million. This is expected to put a downward pressure on interest rate margins and thus support credit recovery in 2011.
5 In 2010, the Government approved subsidized credit lines syndicated through the State Development Bank (HBOR) and commercial banks for working capital totaling HRK2.5 billion (with an HBOR share about HRK 1 billion).
Table 2: Selected Financial Sector Soundness Indicators
Source: CROSTAT
2007 2008 2009 2010ROAA before tax 1.6 1.6 1.1 1.2ROAE after tax 10.9 9.9 6.4 7.0CAR 16.4 15.2 15.8 18.4NPLs / Total loans 4.8 4.9 7.8 11.2Bank provisions / Total loans 54.4 48.7 42.8 38.7Liquid assets / ST liabilities 27.6 23.9 23.7 22.4Interest Rate Margin / Assets 2.6 2.8 2.6 2.8
8
16. The recession raised poverty in Croatia. While available household budget survey (HBS) data has weaknesses6
17. The prolonged crisis led to a defensive restructuring of the corporate sector, further deteriorating labor market conditions in 2010. Although the initial impact of the fall in output on employment was modest, the pace of job destruction has accelerated. Total registered employment fell by more than five percent in 2010, with the active population shrinking by more than two percent from already low levels. The average official unemployment rate increased to 17.6 percent in 2010, four percentage points up from 2008. However, the informal sector somewhat cushioned the adverse employment impact of the crisis
, a simulation of short-term changes in relative poverty between 2009 and 2010 suggests that there was a rise in poverty by two percentage points (to 12.6 percent). Also, the profile of the poor changed somewhat: it comprises now of more economically active, better educated and younger people than before the crisis. However, households headed by elderly without pensions and low educated heads still have highest poverty rates. The fall in employment and real wages led to a reduction in incomes, and consequently pushed many of the unemployed workers into poverty. Looking forward, it will be important to prevent short-term unemployment turning into long-term one and, accordingly, transient poverty into chronic one. Accelerating recovery is, therefore, the prime way to address this issue.
7
18. To support recovery and mitigate social impact of the crisis, the Croatian Government, adopted an Economic Recovery Program (ERP) in April 2010. According to ERP, growth is unlikely to reach pre-crisis levels in the medium term and is estimated to stay below three percent. Attaining higher and sustainable growth rates in the long run will require concerted efforts to reorient the economy towards exports and productivity-based growth. This would require structural changes in public finances, social sectors, education, innovation, privatization and business climate that the ERP proposed to address over the medium term.
. In addition, the downward wage adjustment primarily in the private sector mitigated the adverse impact on employment.
B. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 19. A return to positive but subdued growth is likely. In 2011, the recovery will be mostly driven by still weak domestic and volatile external demand. The projected 2011 growth of 1.5 percent faces a number of risks, as prospects for exports, credit and employment growth depend on robust 6 The representativeness of the HBS sample has deteriorated over time. From 2004, the survey over-represented pensioners or recipients of other social transfers to the detriment of higher-income groups, artificially reducing both the level and dispersion of income and consumption. The 2011 census will strengthen the sample. 7 As suggested by the survey-based unemployment rate of 12 percent in 2010.
Box 1: Financial Sector Stress Test Results
In 2010, the profitability of the banking sector increased by 17.7 percent (based on unaudited preliminary data), with banks’ assets rising by 3.6 percent. The latest stress tests conducted by the CNB show that under the baseline macroeconomic scenario, assuming a 1.4 percent real economic growth and mild appreciation, NPLs should slow down by mid-2011 and reach 13 percent. The overall banking sector would be able to amortize potential losses with operating income -- in case of large banks even increasing capital adequacy (by two percentage points), while banks oriented to companies or riskier household loans would retain their capital adequacy ratios at the current level.
However, under adverse macroeconomic conditions, assuming a real decline of 2 percent and depreciation of currency by 10 percent, NPLs could increase by 110 percent, and reach 23 percent at the end of 2011. However, even under this scenario, the banking sector stability would not be threatened as it would remain well capitalized with a capital adequacy ratio of more than 16 percent.
Source: Financial Stability No.6, 2011, CNB
9
growth in the EU15, sustained improvement in long-term credits to the corporate sector, and recovery of consumer confidence. Private consumption, after declining by estimated two percent in 2010, is projected to slowly recover by 2013 towards the pre-crisis average of three percent. Fiscal consolidation efforts will render the public sector contribution to growth negative throughout the period. The contribution of net exports to growth will become negative from late 2011 as private sector investment recovers and imports gain strength. Unemployment is expected to remain elevated through mid-2011, followed by a gradual decline thereafter.
Table 3: Croatia - Macroeconomic Projections (percent of GDP)
Note: USD terms derived. Fiscal Balance includes consolidated general government adjusted for the pensioners’ debt repayment and Croatian Highways based on GFS86 methodology. For comparison, headline general government deficit based on the national methodology amounts to 4.6 percent of GDP in 2010, 5.0 percent in 2011 and declines to 2.0 percent of GDP in 2013. Source: CROSTAT, CNB, MoF, staff estimates
20. After contracting, external imbalances are projected to remain moderate. The current account deficit, after declining to two percent in 2010, is projected to stay around 3.5 percent of GDP over the medium-term (which is half the pre-crisis levels) led by slight recovery in domestic demand. Export growth (projected at around 7 percent on average over the projected period) will help moderate the current account deficit. FDI is expected to partially recover, mostly from reinvested earnings and the reinvigorated privatization process, as announced by the Government. Although staying at half of the pre-crisis level, net FDIs are expected to exceed the current account deficit over the projected period and thus reduce financing pressures.
EstimateIndicators 2010 2011 2012 2013
National Accounts Real GDP growth -1.2% 1.5% 2.5% 3.0% Total Investment 23.4 24.2 24.9 25.4 Gross National Savings 21.5 21.0 21.3 21.7 Foreign Savings 2.0 3.2 3.6 3.7
Public Sector Primary Balance -3.2 -3.3 -2.1 -0.4Interest payments 2.2 2.5 2.5 2.5Fiscal Balance -5.4 -5.8 -4.6 -2.9
Balance of PaymentsTrade Balance -13.9 -15.4 -16.0 -16.2Current Account Balance -2.0 -3.2 -3.6 -3.7FDI 2.0 3.5 3.8 3.9
DebtForeign Debt 99.8 99.3 95.8 89.9Public Debt (incl. gov't guarantees) 57.9 60.7 62.1 61.5
Gross Internat. Res. (in months of Imports G&NFS) 6.9 6.3 5.7 5.2Memo items:GDP (US$ millions) 60,830 62,162 65,233 70,000Inflation (p.a., %) 1.1 2.7 2.6 2.5Debt service to export ratio 37.7 45.9 40.1 35.4Exchange rate HRK:US$ (p.a.) 5.50 5.55 5.58 5.50
Projected
10
21. Under these circumstances, Government’s strategy is to safeguard stability through front-loaded expenditure-based fiscal adjustment. The 2011-2013 budget aims to achieve a primary balance by 2013 and stem further public debt growth. To improve competitiveness and improve productivity, fiscal adjustment that relied on tax revenues before the crisis need to be reversed. The tax burden at around 38 percent of GDP deteriorated private sector competitiveness. Social contributions as well as the VAT rate are already high when compared to EU peers. Therefore, the budget envisages an ambitious expenditure adjustment with the fiscal deficit declining towards 2.0 percent of GDP by 20138
i. A freeze of the public sector wage bill based on the assumption that the planned implementation of public administration employment reduction would offset the earlier agreed 0.5 percent seniority bonus and a 2.2 percent wage increase for the education sector.
. This entails a reduction of spending by 4.4 percentage points of GDP, led by:
Negotiations with public sector unions on the basic wage freeze have started;
ii. A further reduction in subsidies to shipyards, railways and agriculture by 0.4 percent of GDP. However, shipyards’ debt will likely be assumed by the Government during the privatization process and increase direct public debt by around 3.5 percentage points of GDP, while debt service cost has already been accounted for in the 2011 budget at around 0.35 percent of GDP;
iii. An already implemented freeze in pension indexation; planned further rationalization of privileged pensions; and an application of strengthened income testing for social benefits would lead to a decline of 0.9 percent of GDP in social benefits;
iv. Centralized procurement for selected goods and services is expected to lead to 0.1 percent of GDP in savings in 2011 alone;
v. Furthermore, the Government aims to significantly step up efforts in tax collection and SOE privatization to ease financing pressures.
8 However, once corrected for off-budget items, as explained under footnote 3, it will reach 2.9 percent of GDP.
Figure 2: General Government Balance, percent of GDP
Note: GFS 1986; balance adjusted for pensioners’ debt and Croatian Highways operations.
-1.6-1.2 -0.9
-3.1-2.8
-4.6-5.0
-3.3
-2.0
-2.9-2.6 -2.5
-5.0
-3.6
-5.4-5.8
-4.6
-2.9
-7.0
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
2006 2007 2008 2009 2010 plan
2010 revised
2011 plan
2012 plan
2013 plan
Headline balance
Adjusted CGG balance
11
Table 4: Fiscal Consolidation Plans, percent of GDP
Note: Fiscal data include consolidated general government adjusted for the pensioners’ debt repayment and Croatian Highways based on GFS86 methodology. For comparison, headline general government deficit based on the national methodology amounts to 4.6 percent of GDP in 2010, 5.0 percent in 2011 and declines to 2.0 percent of GDP in 2013. Source: MOF, staff estimates
22. The corporate sector faces high financing needs in the short term; however, ongoing deleveraging process and fiscal consolidation efforts will reduce external financing needs over the medium term. The large stock of corporate sector FX debt (two-thirds of total) and corresponding large debt obligations maturing over the short term continue to create significant external vulnerabilities. In 2011, non-public sector borrowing requirements amount to 16 percent of GDP out of overall gross external financing needs of 22 percent of GDP (or 56 percent of exports). Three-fourths of these are due to principal repayments. By contrast, public debt service will decline to around 5 percent of GDP in 2011, of which half is due to external creditors.
23. Gross financing needs will decline as repayment requirements recede by 2012. Gross financing needs will recede to an average 18 percent of GDP annually over the projected period. Around one-fifth of financing requirements is projected to come from FDI (retail, banking, oil processing, energy and green-field). The IBRD might cover around 2.5 percent of overall needs with the proposed ERDPL program and the regular disbursement profile. In parallel, the rest of multilaterals (EBRD, EIB, CEB) have announced an increase in their exposures. Debt service to the IBRD will remain around 5 percent of total public debt service.
2008 20092010
preliminary2011 plan
2012 plan
2013plan
Total Revenue 39.9 38.9 37.8 36.3 36.3 35.8 Direct Taxes 18.4 18.6 17.1 16.0 15.7 15.6 Indirect Taxes 16.5 15.3 15.9 15.7 15.6 15.4 Nontax Receipts 4.4 4.6 4.2 4.1 3.8 3.7
Current Grants 0.1 0.1 0.2 0.2 0.8 0.7Capital Revenues 0.5 0.3 0.3 0.4 0.4 0.4
Expenditures and Net Lending 42.4 43.9 43.2 42.1 40.9 38.7Consumption 7.1 6.0 5.8 5.6 5.2 4.9Wage bill 9.1 10.6 10.7 10.5 9.9 9.4Interest 1.7 2.0 2.2 2.5 2.5 2.5Current Transfers 16.0 17.6 18.0 17.2 17.2 16.3Subsidies 2.4 2.4 2.3 2.1 2.0 1.9Capital expenditures 5.9 4.7 4.1 4.2 3.9 3.6Net Lending 0.2 0.7 0.1 0.0 0.2 0.2
Overall balance -2.5 -5.0 -5.4 -5.8 -4.6 -2.9Current balance 3.1 0.1 -1.5 -2.0 -0.9 0.4Primary balance -0.8 -3.1 -3.2 -3.3 -2.1 -0.4
12
Table 5: External Financing and Exposure Indicators, 2007-2013 (percent of GDP, unless otherwise indicated)
Note: External sector indicators are expressed in USD terms. Source: MoF, CROSTAT, CNB, staff calculation
24. External debt is on a declining path, but remains highly sensitive to changes in macroeconomic assumptions. External debt in US$ terms is projected to decline from its peak of close to 100 percent of GDP in 2009 down to 90 percent in 2013. In 2010, the private debt amounted to 70 percent of the total, while short-term debt amounted to 12 percent of the total. Under the assumption of a moderate export performance, the debt to exports ratio will decline to below 210 percent indicating the need to maintain the emerging new growth pattern and continue with structural reforms. The sensitivity analysis suggests that a one-time real depreciation of the exchange rate by 30 percent would result in the external debt to GDP ratio of 138.5 percent in 2013 (as oppose to 108 percent with a one-time real depreciation of 10 percent). The combined shock of a rise in the implicit interest rate by 30 percent, real growth at 2.2 percent throughout the observed period (as opposed to three percent projected in the baseline scenario) and a rise of the non-interest current account deficit to 1.7 percent (as opposed to 0.5 percent in the baseline scenario) would lead to the external debt to GDP ratio of 94 percent by 2013.
25. Overall public debt is expected to decline from 2013 onwards as expenditure-led fiscal consolidation proceeds. With one percentage point of GDP spending reduction per year as envisaged by the medium-term fiscal framework, public debt including guarantees would be reduced to 61.5 percent of GDP in 2013 after reaching its peak in 2012 (Table 3). Without planned policy changes, the primary deficit would stay at 3.2 percent of GDP, leading to a gradual rise in public debt by two
EstimateIndicators 2007 2008 2009 2010 2011 2012 2013
Requirements 20.4 18.3 19.0 19.7 21.7 16.1 14.9 Current Account Deficit 7.5 8.9 5.2 2.0 3.2 3.6 3.7 (of which scheduled interest payments) 2.4 2.8 -2.7 -2.9 -3.1 -3.2 -3.3 Principal Repayments 11.2 9.9 11.6 17.6 18.8 13.0 11.5 Official creditors 0.9 0.8 0.7 0.7 0.8 0.8 0.8 o.w. IBRD 0.2 0.2 0.2 0.2 0.2 0.2 0.2 Banks 1.3 1.2 1.6 2.0 2.3 1.9 1.7 Other private 9.0 7.9 9.4 14.9 15.8 10.3 9.0 Increase in net official reserves 1.7 -0.6 2.1 0.2 -0.3 -0.5 -0.3
Sources 20.4 18.3 19.0 19.7 21.7 16.1 14.9 Foreign Investment (net) 7.9 6.7 2.6 2.0 3.5 3.8 3.9 Portfolio Investment (net) 0.1 -1.2 0.6 0.8 0.4 0.4 0.4 MLT Disbursements 17.6 16.2 13.9 15.1 16.3 10.9 9.9 Official creditors 1.5 1.7 1.2 2.1 2.1 1.6 1.3 o.w. IBRD 0.2 0.5 0.3 0.7 0.5 0.4 0.1 Banks 3.3 2.6 3.1 2.9 2.9 2.6 2.0 Other private 12.8 11.9 9.5 10.1 11.4 6.8 6.5 Short-term & other capital (net) -5.2 -3.4 1.9 1.9 1.5 1.0 0.7
Debt and debt service indicators, % TDO/XGS 188.5 183.8 267.5 245.7 235.7 222.7 208.3 TDO/GDP 81.6 79.5 97.6 99.8 99.3 95.8 89.9 TDS/XGS 35.3 27.3 44.9 36.9 44.9 39.2 34.6 Interest payments/GDP 2.6 2.7 2.5 2.4 2.6 2.6 2.5IBRD exposure indicators (%) IBRD DS/public DS 6.5 7.4 5.6 5.5 4.2 5.2 4.9 IBRD DS/XGS 0.6 0.6 0.8 0.7 0.7 0.7 0.5 IBRD TDO (US$m) 1,086.5 1,215.0 1,228.7 1,434.9 1,625.2 1,716.3 1,676.0
ProjectedActual
13
percentage points of GDP per year. The sensitivity analysis suggests that a one-time real depreciation of the exchange rate by 30 percent would lead to a surge in the public debt to GDP ratio by 15 percentage points by 2013. Figure 3: Public Debt Sustainability Figure 4: External Debt Sustainability
Note: One-time real depreciation of 30 percent and constant primary balance at 2010 level. Source: Staff calculations.
Note: Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.
26. Given macroeconomic uncertainties, further efforts would be required to achieve the desired fiscal targets if underlying assumptions change. To this end, options are to frontload planned spending reform measures, such as improving the targeting of social benefits, rationalizing public administration, or scaling back subsidies as envisaged in Government’s ERP, since reverting to one-off measures or tax increases would adversely affect living standards and businesses competitiveness. Public sector borrowing requirements are declining in 2011 to around 10 percent of GDP which reduces immediate risks, but not pursuing the Government proposed fiscal strategy makes the medium-term outlook high risk.
27. Even though there are substantial risks to the economic outlook, the macroeconomic policy framework is considered adequate for the purposes of the proposed ERDPL. The set of macroeconomic policies proposed in ERP, if implemented, provide grounds for a recovery from 2011 and beyond. The announced policies are expected to support economic recovery, but also keep external and fiscal balances manageable. Policy-makers need to remain vigilant and prompt measures need to be taken in case of a slower than expected recovery. Slower than projected growth in Croatia would further strain the fiscal stance, the corporate sector and consequently the banks, and could further raise social tensions.
III. THE GOVERNMENT’S PROGRAM AND PARTICIPATORY PROCESSES
28. The crisis has provided an impetus and a broad consensus for the Government to move ahead with the medium-term reform agenda. While the Government has made substantial progress in harmonizing legislation and regulations with the EU acquis, there is still broad implementation agenda, particularly in non-acquis areas. Recognizing that a quick rebound to pre-crisis growth rates is unlikely if not accompanied by structural reforms to strengthen the competitiveness of the economy, the Government announced a comprehensive Economic Recovery Program (ERP) in April 2010 (Box 2). The program aims at: (i) securing macroeconomic stability through social sector, public administration and state aid reforms; (ii) improving the business environment with the finalization of the privatization agenda, acceleration of judicial reform and the anti-corruption efforts; (iii) increasing
30 % depreciation
Baseline
No policy change
40
45
50
55
60
65
70
75
80
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
30% depreciation
Baseline
Combined shock
40
50
60
70
80
90
100
110
120
130
140
150
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
14
the contribution of labor to growth by addressing skill mismatches through education reforms and advancing the flexibility of the labor market; and (iv) supporting knowledge-based and sustainable long-term growth.
29. The ERP received broad support from political and social partners, as well as IFIs, at the outset. However, the implementation of the ERP has proven to be difficult so far with a number of affected groups expressing opposition to reforms. This has led to changes either in: (i) the sequencing of labor market reforms whereby the duration and the level of unemployment benefits was reduced before labor market rigidities were reduced to encourage employment; or (ii) softening of initial reform proposals in the pension insurance area, thus limiting the fiscal impact over the short term. The Government has publicly emphasized that renewed growth would not be achieved without restoring private sector confidence and private sector investment, both of which have been seriously hit during the crisis, which would then affect employment growth. It is therefore of the utmost importance to try to respect initial reform proposals to seize their full benefits over the medium term and secure growth foundations.
30. Boosting growth requires actions on several fronts, as outlined in the ERP, and the ERDPL supports a subset of them. While the EU support is expected in the areas directly relevant for the internal market and enforcement of the acquis, the ERDPL focuses on two pillars with
Box 2: Croatia’s Economic Recovery Program
Source: Government of Croatia (www.vlada.hr)
Key pillars Key activities: Timeline:Tax system reform (PIT and non-tax fees) June 2010Adopting new legislation on fiscal responsibility November 2010Staff rationalization by 5% Q4-2011Introducing of a merit-based salary system Q4-2011Better targeting of social benefits December 2010 - slippingReducing administration cost of the second pillar December 2010Rationalizing the hospital network and copayment exemptions July 2010 Reforming the first pillar of the pension system July 2010 Reducing and reforming privileged pensions December 2010 - slippingTeritorial re-organizational reform 2013Subsidies' reform December 2010 - slippingPrivatization of minority shareholding ongoingIntroducing e-taxation November 2010Restructuring of SOEs ongoingWider usage of concessions Q4-2011Resolving inter-enterprise arrears originating from public entities ongoingEnforcing stricter payment discipline ongoingRationalizing the court network December 2010 Reducing backlogs ongoingEnhancing enforcement July 2010 Strengthening the bankruptcy system July - December 2010Moving labor market reform towards “flexicurity” June 2010Reducing the duration of unemployment benefits to support job search November 2010 Tackling skill mismatches and long-term unemployment ongoingReforming higher education November 2010 -slippingSupporting lifelong learning December 2010 -slippingRationalizing non-teaching staff (legal framework) July 2010 Promoting key infrastructure investments and R&D ongoingLaw on Science introducing performance contracts in public RDI November 2010 -slippingAdressing further environment protection through better use of EU funds Q1 2011Promoting energy efficiency and use of renewables investment ongoingSupporting international mobility of students and researchers Q1 2011
Supporting knowledge-based and sustainable long-
term growth
Securing macroeconomic stability through fiscal
coinsolidation
Improving the business environment
Increasing the contribution of labor
15
immediate impact on growth and macro stability. These are: (i) enhancing fiscal sustainability through expenditure-based consolidation; and (ii) fostering private sector growth. Both areas have been flagged in the EU 2010 Progress Report as areas requiring immediate Government attention.
A. ENHANCING FISCAL SUSTAINABILITY THROUGH EXPENDITURE-BASED CONSOLIDATION
31. The macroeconomic stability is essential for growth recovery. To preserve macroeconomic stability (which is a precondition for growth), there is a need to pursue further and more rapid fiscal consolidation for at least two reasons: (i) to reduce the burden of debt and distortionary taxation thus facilitating faster private sector growth; and (ii) to make room to adjust over the cycle and react to shocks thus reducing external imbalances evident in significant external indebtness. Current fiscal vulnerabilities are threatening to derail long-preserved macro stability. The proposed ERDPL series will support efforts to mitigate them.
32. The EU accession process has provided an impetus to strengthen public finance management in Croatia. Harmonization with the EU, both in legislation and in practice, has been satisfactory and Croatia closed Chapter 32 - Financial Control-- of the acquis. Auditing, accounting and reporting standards for the public sector have been strengthened, and internal audit and control functions have been established across the public sector. The budget execution process has been steadily strengthened through the expansion of the treasury single account, and in 2009 the Ministry of Finance (MoF) launched the integration of financial management information systems used by line ministries. These processes and controls aim to strengthen fiscal discipline and increase the transparency of public finances.
33. However, these efforts notwithstanding, Croatia’s high public debt with guarantees (in 2009 close to 50 percent of GDP) and rigid public spending levels (above 44 percent of GDP), rendered fiscal stimulus infeasible as the global crisis hit in 2009. Since 2003 there has been an annual budget revision to accommodate expenditure increases. Until 2008 the general government deficit was contained at a relatively low level as revenues over-performed. However, fiscal policy was not counter-cyclical and led to a further build-up of public debt. The recession has worsened the fiscal outcomes further, and is threatening the achievement of key Maastricht criteria (deficit at below 3 percent and public debt at below 60 percent of GDP) – a requirement for the future euro zone entry.
34. Croatia’s fiscal position has significantly weakened over the past two years, reflecting the impact of the crisis as well as a structural deterioration, the latter stemming largely from the spending rise. As discussed in the previous section, the recession put public finances under severe pressure and necessitated adjustments to original budget plans in 2009 and 2010. In the last two years, the Government adopted several budget revisions. Only in 2010, the general government deficit was revised up by almost 2 percentage points of (the revised) GDP taking into account weaker-than-expected economic activity. After 2008, primary expenditure has grown in excess of nominal GDP, with social transfers and the public wage bill accounting for a significant part of that increase.
35. Short-term actions taken at the crisis onset to stabilize public finances have to be replaced by more sustainable, longer-term measures. To safeguard macroeconomic stability, the ERP proposed expenditure-led fiscal consolidation that would require social sector (pensions, health and social benefits), state aid and public administration reforms. Not only that these three areas account for three-fourths of total general government spending9
9 Wage bill amounts to 10.7 percent of GDP, pensions 10.5, health 6.9, social benefits and subsidies each amount to 2.3 percent of GDP.
, but there are also concerns about their spending efficiency. If left unaddressed, weakened public finances and structural factors could adversely impact fiscal sustainability. The ERDPL series aims to support expenditure consolidation measures that would lead to longer-term sustainability of selected areas of public finance (pensions,
16
health, social benefits and public sector wage bill) and the legislative strengthening of the fiscal responsibility framework.
Strengthening the Fiscal Responsibility Framework: 36. Croatia has in the past introduced several formal and informal fiscal rules, but their enforcement has been weak. The 2008 organic budget act introduced a ceiling to the direct debt to GDP ratio at 60 percent. In addition, any legislative proposal adopted within a fiscal year cannot become effective unless funds have been secured in the budget proposal that is based on an ex ante fiscal impact assessment (FIA) approved by the Ministry of Finance. Furthermore, there is a nominal expenditure ceiling and a budget balance (as percentage of GDP) rule introduced through the Medium-Term Economic and Fiscal Guidelines, which are revised annually and receive political commitment from the Government. However, enforcement of these rules has been weak, which has resulted in the rise in fiscal vulnerabilities. 37. To supplement existing rules and further promote long-term fiscal sustainability, transparency and fiscal discipline, the Parliament enacted a Fiscal Responsibility Law (FRL) in November 2010. The law introduced two fiscal rules: temporary and permanent. The temporary expenditure-based fiscal rule aims to reduce a general government spending by one percentage point of GDP per year until the primary balance reaches equilibrium or is positive. After that the permanent rule that aims to “sustain long-term cyclically-adjusted primary balance” starts to operate. If the rules are implemented as planned, public spending is projected to fall from 43.2 percent of GDP in 2010 to around 38.7 percent of GDP by 2013.
38. In addition, the Government established a Fiscal Policy Board in March 2011 to monitor the implementation of new fiscal rules and ensure their credibility by highlighting any deviations from targets in real time and recommending corrective actions to remedy those. Under the ERDPL1, the Bank supports both the enactment of the FRL and the establishment of the Fiscal Board through the Government Decision. The Government is planning to assess the effectiveness of the fiscal responsibility framework after a year of implementation and strengthen it if and as needed. The ERDPL2 would support that.
Public Administration Reform:
39. Public administration is costly to Croatia. At 10.7 percent of GDP, the public sector wage bill is high compared to EU peers. Rationalization of public administration remains high on the Government agenda, as announced in the ERP. However, instead of the announced 5-percent reduction in civil service employment, the staffing reduction in 2010 was less than one percent. The current rule applied is “two for one” – one newly employed replacing two current civil servants, but the rule is not effective to reach the objective of 5 percent staffing reduction. The Government would thus need to take stronger measures to control wage increases, and to pursue further rationalization of public administration. However, the current Civil Service Act makes it difficult to lay off non-performing staff, so any rationalization is happening due to natural attrition or better employment opportunities in the private sector for high performers.
40. To enhance mobility, strengthen the appraisal system and disciplinary measures, as well as facilitate service outsourcing, the Government submitted the amended law on civil service to Parliament on March 2, 2011. The amendments will allow for automatic dismissal of unsatisfactory performing staff which currently could underperform for two years before being subject to disciplinary measures. Further, amendments allow for flexible one-year fixed-term contracts, non-existent at the moment, and outsourcing of auxiliary and technical services. The Government set up the Human Resources Management Information System (HRMIS) with the full deployment launched at the end of March 2011 after the Parliament enacted the Law on Public Sector Employees Registry on March 11, 2011. The law establishes the central registry of public sector employees receiving wages from the
17
State Treasury, while ensuring adequate protection of personal data. The HRMIS will allow for a full wage bill control as well as improved performance and promotion recording, consequently leading to rationalization of wage costs. Under the ERDPL1, the Bank supports the submission of the amendments to the Civil Service Law to the Parliament and the enactment of the new Law on Public Sector Employees Registry.
41. Five years after the enactment of the current Civil Service Law, the legal framework supporting the implementation of the law is still incomplete. The redesign of the civil and public service wage system to promote merit-based principles of pay and promotion is still waiting for unions’ agreement. There is also a need to bridge the gap between ‘de jure’ and ‘de facto’ elements of human resource management in civil service, including on depoliticization, performance appraisal and performance management, job classification and linking training to career development. This has been also outlined as a priority for the EU accession process.
42. Consistent with the ERP, the Ministry of Administration intends to finalize the reform of the public sector wage system. Over the next year, it intends to propose a single law for all public sector positions, including those in local self-governing authorities, and introduce merit-based principles of pay and promotion. The preparatory work is well underway, and consultations with social partners are ongoing. The draft law aims to support merit-based principles of pay and promotion and allow for ‘equal pay for equal work’ principle to be applied across the administration. Namely, the draft law aims to eliminate multiple bonuses provided regardless of the staff performance including the seniority bonus of 0.5 percent per year spent in public service. A new wage system would allow rewarding high performers to avoid a brain drain, but would at the same time rationalize wage costs. Under the ERDPL2, the Bank proposes to support the enactment of the new Law on Unified Public Administration Salaries.
Increased Efficiency of Health Financing:
43. Given its level of economic development, Croatia has comparatively good health outcomes; but in terms of overall health spending at 7.8 percent of GDP, Croatia is in the top tier of health spenders when compared to new EU members10. The generosity of health benefits11
44. In this context, the Government agenda has been to improve fiscal sustainability of the health system and to reduce outstanding arrears while investing in improved patient access. The Government started its reform program by enacting health legislation in December 2008. The measures included in the Acts on Compulsory and on Voluntary Health Insurance increased health sector revenues by: (i) properly budgeting Government’s obligations for financing those groups of individuals defined as exempt; (ii) earmarking the increase in the excise tax on tobacco for health; and (iii) mobilizing increased private revenues through an increase in co-payments and premiums on the
has put a significant pressure on public expenditures, and there is a continued problem with health arrears (despite efforts to instill fiscal discipline, arrears still accounted for 1 percent of GDP at the end of 2009). Health expenditures are almost entirely publicly funded (estimated at nearly 85 percent), and health insurance contributions have been the main source of financing (estimated at 91 percent).
10 In terms of per-capita spending estimated at PPP, Croatia spent US$1,496 in 2008 which was less than countries such as the Czech Republic and Slovenia and a little more than in Hungary. 11 Croatia has a broad national health insurance system: (i) the coverage of individuals is near universal; and (ii) the package of services is broad with few limitations. Co-payments have been increased since the revised 2008 health legislation, but 79 percent of the population is protected against the co-payments (with exemption of drugs above the base reference price) either by being exempt (children under the age of 18), the “supplementary” insurance, or supplemental insurance with state resources. There is also a need to improve usage efficiency and organization of existing resources in non-acute specialized services as evident by waiting lists for specialized services.
18
“supplemental”12
45. As part of the ERP, the Government has adopted several new policy measures that relate to pharmaceutical spending and rationalization of co-payment exemptions, as well as to further increase the efficiency of hospital spending, which the ERDPL1 is proposed to support. Some of these measures will have an immediate effect; others are more structural in nature and gains will be seen only in the medium to longer term:
insurance. At the same time, the Government initiated measures to reduce inefficiency and achieve savings in sick leave administration, payment mechanisms to hospitals, and in the pricing of pharmaceuticals.
• Pharmaceutical Spending Rationalization. The public health budget spent on pharmaceuticals (around 24 percent compared to average 15 percent in new Europe) and its annual growth has been a significant concern. Despite the price benchmarking, international tendering, and the introduction of modest co-payments, the Health Insurance Fund (HZZO) has not been able to stop the rise in volumes of drugs being sold. In response, two ordinances that regulate the pharmaceutical market were introduced13 in 2009 which further defined the criteria for inclusion of drugs in the Positive Drug List and increased the transparency of the process. HZZO now uses several types of risk sharing agreements14 to ensure that suppliers have a financial interest in ensuring that the volumes prescribed are in line with budget limits. Through these ordinances, Croatia was the first country in the world to implement national ethical marketing practices of pharmaceutical companies (through an innovative revolving fund15), restricting their practices of promoting drugs through doctors’ offices and requiring them to be transparent as to how they are spending their marketing budgets. HZZO’s has been able to clear the arrears on prescription medicines in 2010 and in parallel extend the list for innovative drugs16
• Rationalization of Co-payment Exemptions. The 2008 Compulsory Health Insurance Act increased co-payments on the basic package of health services (with the exception of those services provided to children up to the age of 18 years) at 20 percent of the invoiced amount or flat fees established for primary health care visits, prescriptions and diagnostic services. To avoid that increased out-of-pocket expenses become a barrier to accessing needed services, the “Supplemental” Health Insurance (SHI) offered by HZZO, as well as a few very small private insurers, insures individuals against these co-payments. The Government covers the SHI premium for exempt categorical groups (low-income pensioners, disabled, and the unemployed). To reduce the error of inclusion, an amendment to the Complementary Health Insurance Act was enacted in June 2010 applying an income test to families currently eligible for publicly-
.
12 The additional insurance sold by the national health insurance is complementary in nature, covering all co-payments except those on the ‘B’ Drugs List. The supplemental insurance is the common term used in Croatia for such insurance. 13 (i) Ordinance on establishing the criteria of wholesale pricing and reporting wholesale prices of medicines; and (ii) Ordinance on establishing the criteria for inclusion of medicines in the basic and supplementary reimbursement lists of the Croatian Institute for Health Insurance (HZZO) (OG 155/09). 14 Specifically, Pay Back Agreements define maximum expenditure limits for a particular drug and trigger reimbursements or donations of the pharmaceutical company if exceeded; and Cross Product Agreements allow the listing of one drug (usually an innovative drug) on condition of reducing the price of a second drug resulting in a neutral or positive budget impact for HZZO. 15 To be reimbursed each quarter, pharmaceutical companies must deposit their marketing budget in a fund with HZZO and report on the use of those funds. As of November 2010, 56 such agreements had been signed. Entering into ethical marketing agreements is voluntary, but mandatory for adding new drugs to the market. 16 In the 12-month period from July 2009, as many as 47 innovative molecules were added to HZZO’s lists of reimbursed medicines and 13 innovative molecules to its list of expensive hospital medicines. By comparison, a total of 45 were listed during the period 2002-2009.
19
financed SHI (except for 100-percent disabled)17
• Hospital Sector Consolidation. Croatia does not have the hospital excess-capacity problem as many other countries in the Central and Eastern Europe
, effective from January 2011 as each individual seeks renewal of his or her SHI policy. It is expected that the exempt population will decline by around one-third by mid-2011. A gradual application of a proper means testing to ensure the publicly financed benefit captures those in need will be introduced as the OIB (Personal Identification Number) gets implemented across the government bodies, starting in 2012.
18, but it still has ample room to optimize the hospital in-patient capacity. National figures also hide geographic concentrations of service, since Croatia has a large number of hospitals in Zagreb (more than two per 100,000) of which several are small and narrow profile hospitals. There is scope for hospital rationalization given duplicate administrative costs, the long average length of stay, high turnover and varying costs of medical and other supplies from one hospital to the next. In June 2010, the Ministry of Health and Social Welfare adopted a revision of the Public Health Institutions Network seeking to consolidate 16 hospitals in Zagreb into six hospitals19, but was able to influence the consolidation of nine state-owned hospitals into four as the city Government disputed the national Government’s authority to order the mergers of municipality-owned hospitals. However, HZZO adopted the 2011 hospital budgets per the consolidated hospital network. The expected annual savings from the hospital network rationalization amounts to HRK300 million after five years, with the savings in 2011 amounting to HRK50 million20
46. Given the declining budget
. The savings achieved will be used to further reduce outstanding liabilities as well as to invest in service improvements.
21
17 The income threshold is an average of HRK1,516 a month in the previous year per household member.
, and the need to reduce public health debt and health arrears, further administrative measures are planned to be implemented in 2011. For example, the Government is introducing a national system of e-prescriptions to reduce paperwork of patients, doctors and pharmacists and to increase the capacity of HZZO to monitor and control drug expenditures. Similarly, the standardization and classification of medical equipment and the development of the medical equipment registry have commenced. With the categorization of hospitals, the Government will improve the regulation of medical equipment procurement which will facilitate cost reductions and a proper deployment of medical technology. Similarly, the categorization and standardization of orthopedic devices and disposable medical material as well as the centralization of its procurement will further rationalize costs. In the area of SHI, gradual application of a more targeted
18 Croatia has 1.8 hospitals per 100,000 and 549 hospital beds per 100,000 whereas older EU member states have near 2.7 hospitals per 100,000 and about the same number of hospital beds. 19 The plan was based on international best practice examples of consolidating hospital networks and concentrating management over a network of facilities to achieve economies of scale, facilitate optimization of capacity and other efficiency improvements. A few higher income countries - including the UK, Australia (State of Victoria), Denmark (Copenhagen-Friedrichshaven), Austria and Hong Kong, as well as Estonia were used as examples. The merged hospital networks in these countries also operate under financial rules and provider payment arrangements that allow them to keep efficiency gains they make through rationalization. Administrative closures or centrally controlled management of internal hospital organization have been far less successful. 20 The largest merger of the state owned hospitals involved the Sisters of Mercy University Hospital and three smaller hospitals in Zagreb as of July 1, 2010. The immediate effect was the consolidation of the Board of Directors from 20 members to 5 members and a reduction of staff from 4182 to 4123 (largely non-medical). Through the economies of scale for consumable medical supplies the merger also resulted in a monthly savings of HRK 2.6 million in operating expenditures. The hospital arrears in the first three months following the merger were reduced by 8 percent. 21 To meet the overall public expenditure and fiscal deficit targets of the Government, the 2011 budget of HZZO is reduced by HRK 300 million and is expected to be further reduced by HRK150 million in 2012.
20
means-testing to determine the eligibility for public financed basic and SHI is planned. Under the ERDPL2, the Bank proposes to support the further rationalization of pharmaceutical spending through the national implementation of e-prescriptions; the standardization and classification of medical technology and orthopedic devices; and the application of means-testing to health co-payment exemptions for social categories of insures.
Social Welfare Reform:
47. The social assistance system in Croatia is costly, complex and plagued by administrative inefficiencies. In 2009, even excluding spending on war veterans, civilian disabled during the war and their survivors – a burden that many other transition economies do not have -- Croatia’s spending at 2.3 percent of GDP tops that of other transition economies, except Bosnia-Herzegovina and Hungary. The overall spending mix is biased towards categorical programs, with means-tested programs playing a marginal role (they accounted for 8 percent of total spending in 2010 or around 0.4 percent of GDP; an increase compared to a year earlier).
48. At the same time, the social assistance system covers most of the poor and vulnerable population, is generous, and relatively well targeted. As of 2009, the social assistance system was reaching 52 percent of the poorest 20 percent of the population (ranked based on pre-transfer income); including pensions, the coverage of the pre-transfer poorest 20 percent was 98 percent. However, the number of programs on offer, the number of institutions involved, and the lack of harmonization on eligibility criteria has led to a costly system to administer and causes unequal treatment of claimants. This has resulted in confusion, and errors of exclusion and inclusion which negatively impacts value for money.
49. As planned under the ERP, the Government adopted the Social Welfare Reform Strategy for 2011-2016, and has submitted the new Social Welfare Law to the Parliament for enactment in March and April 2011. The Master Plan for Social Welfare Institutions was adopted in February 2011. Key objectives of the reform program are to reduce social exclusion and improve efficiency of the social welfare system through: (i) improved social benefits targeting; (ii) consolidated system administration; (iii) strengthened system control; (iv) introduction of social mentors and activation elements to social assistance; (v) reduced scope of institutionalized care; and (vi) strengthened provision of community-based social services. In the draft law on Social Welfare the best targeted social assistance benefit (poverty benefit) is proposed to be linked to the poverty line to protect its further deterioration. The new regulation seeks the rationalization of the system administration so that the current 86 centers for social welfare would be streamlined to 21 county-level centers with adequate network of branches ensuring broad access with one-stop-shop services provided to beneficiaries. Under the ERDPL1, the Bank supports the adoption of the Social Welfare Strategy and the submission of the new Social Welfare Law to the Parliament for enactment.
50. To ensure that uniform targeting criteria will be used across the social benefits providers, the Government plans to propose a national law obliging the use of means-testing instead of income-testing targeting mechanism in 2012 when the application of the personal identification number and income and asset cards are fully deployed. Such a proposal has already been discussed at the inter-ministerial working group which developed the registry of social benefits. Preparations for a full deployment of asset cards in 2012 are ongoing. At the moment, the tax administration is finalizing the form containing income and asset information of tax payers and their family members to enable the use of means-testing across the administration and avoid errors of inclusion in the country with high income under(non)reporting. Under the ERDPL2, the Bank proposes to support the extension of the means-testing to all social benefit programs.
21
Improving Pension System Equity and Financial Sustainability:
51. As a result of 2007 pension system interventions22
52. In 2009, the Government reverted to short-term measures to claw back the spending hike. They included: (i) a suspension of pension indexation in 2010
and the impact of economic crisis, the share of pensions in GDP increased to 10.5 percent in 2010. These interventions exhausted savings stemming from the parametric reform of the generational solidarity (PAYG) pillar launched in 1999, and postponed further capitalization of mandatory privately-funded pension funds (so called second pillar) from the current contribution rate of only five percent.
23; (ii) a reduction of monthly pensions above a certain threshold; and (iii) a reduction in pensions of Government members, Members of the Parliament, and Constitutional Court judges by 10 percent from August 2009, to bring them closer to general benefits24. The Law on Homeland War Veterans’ Rights was amended in October 2009 to close the war disability window and abolish the eligibility for the minimum pension for all veterans with less than 100 days in combat25. It is expected that with these amendments there would be no new claimants for disability veterans’ pensions after 201126
53. The Government has continued the implementation of comprehensive measures announced in the ERP to make the pension system fiscally sustainable over the long run. In October 2010, the Parliament enacted amendments to the Obligatory Pension Insurance Act, which the Bank is proposed to support under the ERDPL1. Those amendments: (i) increased the retirement age for women from current 60 to 65 in 3-month increments per calendar year until 2030; (ii) increased the early retirement decrement for all new pensioners below 40 years of service in proportion to the service period; and (iii) introduced a 1.8 percent per year bonus for late retirement. While the higher decrement for early retirement will slow the pensioners’ inflow already in 2011, the fiscal impact will be substantial only in the medium to long run. A relatively long period between the announcement and the enactment of tightened early retirement rules caused a rush to early retirement in 2010. So in order to ensure fiscal stability, the Parliament enacted in December 2010 a Law on Postponement of Pension Indexation that suspends pension indexation until early 2012
.
27
54. The ERP announced further steps to rationalize privileged pensions. In June 2010, the Law on Reduction of Privileged Pensions was enacted which reduced privileged pensions by 10 percent above a threshold of HRK3,500
.
28
22 These included (i) reducing early retirement decrement from 0.34 to 0.15 percent per month; (ii) raising minimum pension for years of service above 30; and (iii) new pension supplement up to 27 percent for pensions initiated after 1998.
. This measure was the first step in a planned series of changes to bring selected pension privileges closer to the general system. In March 2011, the Government submitted the amendments to the Law on Rights and Responsibilities of the Members of the Parliament to the Parliament, aiming to increase the retirement age and the minimum service period for MPs, Government officials and Constitutional Court Judges bringing them thus closer to the
23 Contrary to expectations, had the indexation formula not been suspended, pensions in 2010 would have declined in nominal terms and the nominal pension freeze in 2010 generated additional cost (around HRK50 million). 24 Pension rules for HWV, MPs, and some other categories differ substantially and are up to four times higher than the average old-age pension. 25 The initial minimum pension for Homeland War veterans was set at 45 percent of the average wage in the country regardless of length of service and service period. 26 The backlog of disabilitrypension requests has been reduced to 2,000 by the end of 2010. 27 In 2011, this measure will yield savings of around HRK400 million. 28 The Law reduced all privileged pensions by additional 10 percent after the HRK 3,500 threshold which saved around HRK 600 million. War veterans with 100 percent disability were exempt.
22
general system29
55. To reduce the administrative cost of the second pillar, HANFA adopted a Decision to reduce the mandatory pension funds’ asset management fee from 0.75 to 0.65 percent in December 2010, supported by the ERDPL1. This being still on a high side led the authorities to draft the amendments to the Law on Unified Personified Pension Data Collection (so-called Law on REGOS), with the objective to share the operating costs of the second pillar with the mandatory pension fund administrators.
. There are marginal fiscal savings stemming out of these changes, which represent only an initial step towards a comprehensive reform of privileged pensions. The Bank supports the enactment of the above measures under the ERDPL1, with the extension of the privileged pension reform to other categories under the ERDPL2.
56. Further measures need to be taken during 2011-2012 to ensure long-term sustainability and fairness. They relate to the increase in the second pillar contribution rate, addressing differences in pensions between multi-pillar and “old system” participants (including the 2007 supplement and the basic pension definition), administrative costs of the second pillar, and further parametric changes of the PAYG pillar30
B. FOSTERING PRIVATE-SECTOR GROWTH
. Under the ERDPL2, the Bank proposes to support enactment of amendments to the Act on Voluntary and Obligatory Pension Funds and the Obligatory Pension Insurance Act and a further reduction in administrative costs in funded pension pillars.
57. Growth recovery will depend on emergence of a dynamic private sector. A conducive business environment is vital for increased private sector investments, domestic and foreign, in both new and existing enterprises. Evidence across transition countries show that a country that provides new entrants with a friendly investment climate (without excessive regulation or corruption), see rapid entry and growth of firms. Reallocating the capital of un-restructured and failing firms does, however, require a framework for bankruptcy and liquidation that frees the tied-up capital for alternative, higher productivity uses.
58. The ERP recognizes that there is a need to refocus the role of the Government from the lender of the last resort to a provider of an enabling environment. To that end, it focuses on cross-cutting structural reforms that can benefit the whole economy, which means changing the economic governance, including the regulatory environment, fighting corruption, increasing labor productivity, protecting investors, and providing access to finance. This would mean disrupting the soft-budget constraints and high subsidization that have led to constrained enterprise restructuring and new business development.
59. A better investment climate will encourage investment flows, thus contributing to export expansion and job creation, urgently needed in the country with historically high unemployment. A key priority in this regard is enhancing the competitiveness of the economy to promote private sector led growth through measures that the ERDPL series proposes to support, such as: (i) increasing the labor market flexibility and enhancing incentives for higher labor force participation; (ii) improving the investment climate by removing administrative barriers for investments and private sector growth (including through ensuring efficient entry and exit of firms, finalizing the land registration/cadastre upgrading and the enforcement of contracts); (iii) undertaking faster privatization of non-strategic enterprises; and (iv) strengthening the innovation framework.
29 According to the current law, MPs can acquire a pension at 55/50, after half parliamentary mandate and a total of 20 years of service. MPs pension is set at 65 percent of MPs last wage with additional 2 percent for each year of service above 20, but subject to a maximum replacement rate of 85 percent. 30 The impact of the proposed policies is being simulated using the PROST model.
23
Increasing labor market flexibility and incentives for labor force participation:
60. The labor market remains depressed in Croatia with unemployment rising above 12 percent. The number of persons registered as unemployed is currently about 30 percent higher than before the crisis. About half of the registered unemployed have been jobless for more than a year, which negatively affects their re-employment chances due to the erosion of skills and morale. Moreover, the outflows from unemployment to jobs are low since employers refrain from hiring and job vacancies are few. Employment has continued to fall as well with the number of jobs in the formal sector currently eight percent lower than before the crisis, with the decline in jobs in the last 12 month accounting for over five percent.
61. The steady state unemployment rate, although lower, is above the EU average. The reasons for this are structural: (i) an inflexible labor market due to strict employment protection legislation; (ii) high unit labor costs, reflecting the power of insiders in the wage setting; and (iii) the skills mismatch31
62. The labor force participation rate is low in Croatia, especially among older workers in the pre-retirement age. The main cause is the social protection system which supports early labor force withdrawal and does not provide sufficient job search incentives. The Government is aware that the existing social protection system creates significant labor supply disincentives and that the low labor force participation rate is largely driven by easy access to numerous social benefits. Also long-term unemployment, which is particularly high in Croatia (60 percent of total unemployment), is supported by access to unemployment and related benefits. The recent reforms to the unemployment benefit system, which consisted of lowering the replacement rate and reducing the duration of pre-retirement benefit, were intended to improve job search incentives and consequently reduce the duration of unemployment and increase the economic activity among welfare recipients.
. Economic growth by itself will not suffice to substantially lower the unemployment rate in Croatia. Structural labor market reforms are necessary to enhance the adaptability of Croatian labor market and improve labor market outcomes not only in the short but also in the long term.
63. Under the ERP the Government announced changes to address these problems so that Croatian firms emerge from the crisis more competitive with more productive labor. In November 2010, the Law on Employment Mediation and Unemployment Benefits was amended to introduce two important changes to the unemployment benefit system, which the ERDPL1 proposed to support. First, the benefit replacement rate was reduced from 50 to 35 percent after 3 months of unemployment (the benefit replacement rate is 70 percent of one’s previous wage during the first 3 months of unemployment). Second, the duration of pre-retirement unemployment benefit was limited to 5 years (from unlimited duration for men with 32 years of service and women with 30 years of service) from now increased statutory retirement age. The first measure is meant to strengthen job search incentives for the unemployed, while the second one is intended to limit early retirement and encourage economic activity among older workers. In addition, the recent reduction in the generosity of unemployment benefit should be accompanied by the development of modern activation policies and other cost-effective labor active market programs to improve the employment chances of the unemployed32
64. By 2012, the ERP aims to address obstacles at the supply and the demand side of the labor market. Supply-side reforms aim at further restricting access to social security benefits that support early labor force withdrawal. These reforms need to be accompanied by measures facilitating employment of older workers, such as the development of flexible forms of employment (including part-time work) and the development of life-long learning to allow older workers to update and
.
31 World Bank 2009 Croatia EU Convergence Report and the World Bank 2010 Croatia: Social Impact of the Crisis 32 World Bank 2010 Croatia: Social Impact of the Crisis.
24
upgrade their skills. Demand-side reforms aim at enhancing labor market flexibility in order to foster job creation and productivity growth. Currently, the Labor Law is a source of substantial rigidities, which negatively affect labor market performance in Croatia. Dismissal costs are high in Croatia by regional standards. The possibility to adjust hours worked to the variation of product demand is also restricted, more so than in other countries in the region. Under the ERDPL2, the Bank proposes to support the enactment of amendments to the labor law to increase working hours’ flexibility, employment and wage flexibility and lower layoff costs and notice.
Reducing administrative and regulatory barriers to business:
65. The regulatory framework governing the private sector remains cumbersome in Croatia. The World Economic Forum Global Competitiveness Index persistently identifies inefficient Government bureaucracy as the most problematic factor for doing business. Although there have been recently improvements in the overall business climate33
66. The European Commission’s 2010 Progress Report on Croatia states that judicial reform has continued: case backlogs were reduced in courts and judicial independence was strengthened through constitutional amendments. However, it states that “the main expected results of the reform process are yet to be seen”, in particular in the areas of transparent criteria for the appointment of judges and prosecutors, the further reduction of case backlogs, length of judicial proceedings and the enforcement of decisions.
, an inefficient judiciary still hinders the exit of unviable firms, and execution and enforcement of contracts and property rights are weak compared to EU countries. Closing a business in Croatia still takes on average 3.1 years, while the OECD average is 1.7 years, while the recovery rate is about 30 cents on the dollar compared to 70 cents on average in OECD countries.
67. To facilitate private sector recovery and growth, key actions supported by the ERP focus on improving the investment climate and reducing barriers to entry and exit of firms. The following activities aim to address these concerns:
• In September 2010, the Government adopted an action plan for eliminating investment barriers. It envisages a broad set of measures to obstacles faced by potential investors. These cover business registration, land acquisition, issuance of permits, taxation, trade, and one-stop-shop for investment promotion. Most measures are to be implemented during 2010-2011. During 2011, for example, after the "e-company" application is introduced in all commercial
33 The 2011 Cost of Doing Business ranks Croatia 83rd in the world up from 88th.
Figure 5: Business Environment in Croatia and its Regional Peers, 2010
Sources: World Bank, WEF
0 20 40 60 80 100 120 140
EU 15EU 10
BiHSerbia
CroatiaPolandTurkeyCzech …
MontenegroRomaniaHungaryBulgariaSloveniaSlovakia
MacedoniaLithuania
LatviaEstonia
Doing business 2011(185 countries)
0 20 40 60 80 100 120
EU 15EU 10
BiHSerbia
MacedoniaCroatia
BulgariaRomania
LatviaTurkey
SlovakiaHungary
MontenegroLithuaniaSlovenia
PolandCzech …
EstoniaThe Global
Competitiveness Index 2010-2011
25
courts for online registration of companies, the authorities aim to reduce the founding capital requirements and associated fees for company registration. In 2011, the Government also aims to adopt the amendments to the Spatial Planning and Construction Law which would simplify the administrative procedure for obtaining construction permits and install the rule of 45-day issuance of consent;
• Amendments to the Bankruptcy Act introduced summary procedures from October 2010 for selected cases. About HRK30-50 billion (US$5-9 billion) is estimated to be locked up in over 18,000 bankruptcy cases in commercial courts. Bankruptcy filings increased by about 70 percent during the first six months of 2010 compared to the same period last year34
68. Enforcement of judicial decisions in Croatia has long faced significant organizational and procedural challenges adversely impacting the private sector performance. Complex, inefficient and lengthy procedures delay issuance of writs of execution by courts, and favor debtors. The complex enforcement procedure provides debtors ample opportunity to avoid the delivery of service, object to enforcement actions and in other ways delay the process. Croatian policy makers recognized the challenges constraining effective and efficient enforcement of contracts and have taken important steps to address these issues within the ERP which the ERDPL1 supports. These are:
. Applicable to legal entities with no registered employees and unpaid obligations for over 60 days, the new procedure requires FINA (on behalf of the MoF – Tax Administration) to submit a request to courts to begin summary procedures. After satisfying itself that the ingredients for application of summary proceedings are satisfied and following an advertisement in the Official Gazette for 30 days (to notify all parties) the court can initiate and speedily conclude the summary process. Additional staff, equipment and budget have been allocated to FINA and the courts to cope with the anticipated surge in summary cases.
• New Acts on Enforcement and on Public Bailiffs were enacted in November 2010 and will take effect from January 2012. These laws aim to establish a new, accelerated system for the enforcement of judicial decisions. Implementing regulations are being drafted and will be adopted by the Minister of Justice by mid-April 2011. A key efficiency-enhancing provision is that it seeks to decrease the length of the enforcement procedure outside of judiciary through the institution of public bailiffs whose task will be to enforce judicial decisions;
• A new Act on Execution of Cash Assets enacted in July 2010 also seeks to significantly improve the speed and reduce the cost of complying with writs of execution. Previously, the system for Execution of Cash Assets was ineffective as there were no appropriate tools to gain relevant information about debtors’ cash and deposit accounts (of natural persons) within adequate timeframe. Almost 645,000 payment orders were lying unexecuted by end-2010. Effective January 1, 2011, the new procedure centralized enforcement against debtors’ cash and deposit accounts in financial and credit institutions through FINA which enforces the writ of execution by direct debit from the debtor’s accounts in banks. This is a major policy action which, if implemented smoothly, can change the very landscape of enforcement against liquid assets, improve the business improvement and strengthen governance at the same time.
69. The Government plans to continue with the acceleration of commercial dispute resolution through: (i) the adoption of a new Act on Personal Insolvency late in calendar 2012; and (ii) amendments to the Law on Civil Procedure to permit electronic communications between courts and parties for service of notice and transmittal of decisions and avoid multiple loops between higher
34 The official number of pending bankruptcy cases in fact understates the gravity of issue because dilatory judicial procedures and insufficient information on debtors’ assets provide little incentive for creditors to use formal bankruptcy procedures. Many bankruptcy cases in Croatia are in fact filed by employees against their companies to recover their overdue wages and salaries.
26
and lower-level courts in April 2011. The latter action could be especially significant in reducing the length of judicial proceedings, including in commercial courts.
70. The Government also aims to accelerate land registration process and ensure secure real estate market through development of the Joint Information System (JIS) in land registration and cadastre. In 2010, the JIS has been piloted in two municipal courts to harmonize titles in land registry with cadastre data. By end-2011, the Government plans to roll the JIS out to additional 30 municipal courts approximately covering 20 percent of titles. Currently, around 65 days is needed nation-wide to obtain the land registration certificate, with large variations in the most burdened courts like Zagreb and Split. Under the ERDPL2, the Bank proposes to support the implementation of Joint Information System in land registration and cadastre to reduce duration of land registration.
Reducing state involvement in corporate sector through accelerated privatization process:
71. Croatia’s performance in terms of enterprise restructuring and privatization has been slow and still incomplete. Thus the share of gross value added produced in the private sector amounts to only 70 percent, which is low compared to EU10 peers. There are many companies in the Croatian Privatization Fund (CPF) portfolio which are engaged in commercial business for which there is no clear rationale for the state to be a shareholder. Under the ERP, the Government aims to sell these companies that will compete with others in their sectors on the same level playing-field, ensuring that they respond to the market rather than to political incentives.
72. The Government accelerated privatization of remaining shares in 2010. At the end of March 2011, there were 662 companies (down from 733 a year ago) with some form of state ownership. Out of this, 416 were available for immediate sale and 246 companies are held under reservation until resolution of restitution claims from previous owners. In 2010 and inclusive of January-March 2011, stakes and shares in 76 companies with minority or majority state ownership were sold and 36 liquidated. Going forward, despite running two auctions per month through the stock exchange, the outcome remains modest given the low quality of the CPF portfolio and constrained models for privatization. Also, due to continuous cancellation of sale agreements with the so-called ‘small shareholders’, the number of companies in the state portfolio is decreasing very slowly. This is the result of the old Privatization Law which allowed sale at large discounts in 20 plus years installments.
73. The Government significantly strengthened the institutional framework for management of state property and privatization with the enactment of the Act on Management of State Property in December 2010. The Act merged two institutions35
74. The Government is decisive to resolve the restructuring and privatization of shipyards. A restructuring plan for one (Brodosplit) out of five state-owned shipyards have been approved by the Croatian Competition Agency and the European Commission, while one shipyard (Uljanik) is no longer considered a company in difficulty. The plans aim to ensure long-term viability of shipyard
in the past managing state property into a single Agency for the Management of State Property. A merger of state assets governance would allow for the establishment of a single comprehensive inventory of state assets, acceleration of sale of all minority state shareholdings, privatization of majority shareholdings and currently locked non-core real estate and movable property, except for companies of strategic relevance. By enactment of this Law, the Privatization Act, the Transformation Act and the Act on Croatian Privatization Fund has been put out of force. The law no longer permits installment payments, including a grace period, and prescribes an immediate purchase of shares within the period of six months. The new Law also envisages additional models of state asset sale (responding to takeover bids, recapitalization through initial public and private offers, negotiations) in addition to current models (auctions at the Stock Exchange, public invitation to tender).
35 These are Croatian Privatization Fund and the Central Office for the Management of State Property.
27
operations. The sale contract for the first shipyard is to be negotiated with the accepted buyers by the end of March 2011. Under the ERDPL1, the Bank supports the enactment of the new Law on State Asset Management and the sale or liquidation of at least 100 companies; while under the ERDPL2, it proposes a sale or liquidation of at least 200 companies.
Strengthening innovation framework:
75. Current spending on research and development (R&D) in Croatia – at about 0.8 percent of GDP – is clearly insufficient to shift Croatia’s growth path. Innovation-driven economies, such as Finland, Sweden and Israel, have consistently spent about 3-5 percent of GDP for decades. The concentration of R&D in the public sector, coupled with meager commercialization and insufficient collaboration with enterprises, is another factor hindering the contribution of the R&D system to Croatia’s economic development. In addition, its science-base – the quality and quantity of scientific output-- has been deteriorating owing to a governance structure that uses scarce resources inefficiently, discourages academic excellence and is unsympathetic to young researchers, contributing to a forceful process of brain drain. Business investments are also very low, corresponding to about ¼ Slovenian levels in per capita terms.
76. Under the ERP, the Government aims to strengthen the innovative capacity of the economy. Reaching the R&D goals established by Europe 2020 is likely to generate large positive effects on the country’s exports and income – in fact, the largest among the EU economies in the case of exports. At the same time, required fiscal consolidation efforts affected public funding for R&D in Croatia. Countries around the world have significantly increased R&D investments even during the global economic crisis36
77. A number of actions within the government are underway, or in preparation, to enhance the efficiency and effectiveness of the R&D system. Specifically, the government is undertaking important and well conceived steps to improve the management and prioritization of government R&D spending, including the drafts of a new Science Act and a new Universities Act and the implementation of impact evaluation studies of selected measures. These draft laws represent an attempt to address the unfinished reform agenda, including to: (i) enhance and streamline the legal framework of the science system; (ii) increase the efficiency and collaboration of institutes and universities with businesses and the public sector; (iii) increase investment into science and efficiency of investments, particularly from the private sector; (iv) ensure a more transparent and excellence-oriented science system as well as more open toward the European Research Area; (v) and increase accountability and autonomy of the science system and universities management. Key aspects addressed by the law also include the financing of public universities and institutes through programmatic agreements and external evaluations (as opposed to per headcount); career development based on academic results; emphasis on attracting and nurturing young researchers and enhanced managerial autonomy for public research organizations
.
37
C. CONSULTATION AND PARTICIPATION
. Under the ERDPL2, the Bank proposes to support the enactment of the law.
78. After the broad presentation of the ERP in April/May 2010, consultations on sector reforms have been proceeding at the technical levels. Even though the work of the Economic and Social Council work (a tri-partite body comprising of unions, employers’ associations and Government) was disrupted from May 2010 to March 2011, tripartite consultations on key reforms
36 Last year, the EU made EUR6.4 billion available to promote smart growth and jobs, the biggest investment in R&D ever made by the Commission and an additional effort to reach the Europe 2020 targets. 37 The issues being addressed include several of the challenges identified in the World Bank Croatia: EU Convergence Report, while proposed solutions embrace most of the lessons learned during the implementation of the Croatian Science and Technology Project.
28
(pensions, health, enforcement, social welfare, bankruptcy) have continued. In May 2010, proposed changes to the Labor Law (unilateral cancelation and extension of collective agreements to whole branches) led to a unilateral decision by trade unions to suspend the work of the Council, and call for a referendum against the labor law reform. The draft law was removed from the procedure, but discussions on the needed labor market reform have continued and agreement was reached in March 2011 to proceed with partial revisions of the labor law.
79. Additionally, the Government has carried out a broad consultation process on pension, social welfare as well as innovation policy reforms, with official documents posted on the web sites for the regular consultation period. Government’s communication campaign covered civil society, academia, professional associations as well as broad public through the public electronic media. In the case of the social welfare and the innovation policy reforms presentations and comments received on the proposed legislative changes are still posted on the ministries’ web sites.
80. The consultative process on laws and strategies related to the EU accession agenda continues to be strong. The Government set up 33 core and extended negotiating teams for the same number of the EU acquis chapters. These teams consist of experts, representatives of civil society and academia. Over the last year, the communication with broad public on key benefits of harmonized legislation and the accession have been strengthened. There is a broad national consensus on the EU accession objectives. The Government publishes all laws on its web as well as on the line ministries’ web sites.
IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM
A. LINK TO CPS 81. The Bank Group’s Country Partnership Strategy (CPS) for FY09-FY12 was presented to the Board in September 2008 (Report No.44879-HR). The goal of the CPS is to support, in a selective fashion, the Government’s main strategic priorities in the context of Croatia’s EU accession process: (i) sustaining macroeconomic stability through enhancing the efficiency and effectiveness of public finances and strengthening financial sector supervision; (ii) strengthening private-sector led growth and accelerating convergence with the EU through, among else, enhancing public sector governance; (iii) improving the quality and efficiency in the social sectors through increasing the sustainability and equity of pension systems, improving health system efficiency and outcomes, enhancing the education system to support a knowledge-based economy and improving social inclusion and better targeting of social assistance; and (iv) increasing the sustainability of long-term development. The proposed ERDPL supports the first three goals (i-iii) of the CPS.
B. COLLABORATION WITH THE IMF AND THE EU 82. The latest Article IV IMF mission was conducted in April 2010, and an IMF staff visit was carried out in November 2010 to assess the appropriateness of the 2011 budget and supporting policies to secure macro stability and sustainable recovery. The November mission was encouraged by the substance of Government’s ERP, and advised its swift implementation. It concluded that Croatia’s economy is in need of far reaching and challenging reforms to improve its weak macroeconomic outlook over the medium term. Recovery from the current recession is being impeded by structural weaknesses, reflected in low competitiveness and high underlying fiscal deficits. The mission highlighted significant risks that are linked to the large external financing requirements, concerns about the sustainability of public debt, and the pace of private sector deleveraging. According to the IMF, Government’s objective to reduce the fiscal deficit to 2 percent of GDP by 2013 is broadly appropriate, but will require front-loaded implementation of the planned expenditure-saving measures (in particular public sector retrenchment, privatization, pension and
29
health sector reforms), a more flexible wage-setting mechanism, and better targeting of social benefits. The authorities have not approached the IMF with respect to a possible program.
83. The IMF and the Bank collaborate closely to support the Government in expenditure-led fiscal consolidation, improving tax administration and strengthening competitiveness. The IMF provides policy advice and analysis through its surveillance (Article IV consultations and staff visits) and technical assistance on monetary and exchange rate policies, fiscal policy, financial sector stability and the external sector. The Bank closely liaises with the IMF on the ERDPL-supported reforms.
84. The Bank continues to cooperate closely with the European Commission (EC). The objective of the World Bank support, as outlined in the CPS, is to facilitate successful integration of Croatia into EU and build capacity for effective absorption of the EU structural and cohesion funds. In particular, in the areas of public administration, public finance management, state aid, environment and judicial reform, the Bank and EC closely coordinate policy agenda as well as complementary of financial support. The Bank has selected the ERDPL-supported reform areas so as to ensure a full alignment with the EU acquis where relevant or address concerns from the EU 2010 Progress Report for Croatia.
85. The November 2010 EU Progress Report provided several policy recommendations that the ERDPL proposes to address. Improvements in human resources strategy, introducing a civil service registry, and establishing merit-based principles and reward mechanisms to accelerate depoliticization and maintain and attract qualified personnel, have been recommended. Measures planned under the ERDPL will directly contribute to strengthening the civil servants appraisal system and management mechanism, through legislation changes and introduction of HR management information system to allow broad coverage of the registry to capture all public institutions. Finalization of the reform of the public sector wage system, also recommended by the EU, is currently envisaged to be supported under ERDPL2. In the judiciary area, ERDPL would support speedier enforcement of judicial decisions through the adoption of the new Enforcement, Bailiffs and the new Act on Execution of Cash Assets, which was flagged by the EU as one of the areas necessary to improve efficiency of judiciary, which is one of the benchmarks (i.e. improved efficiency of judiciary) for closing the EU negotiations under the Chapter 23 - Judiciary and fundamental rights. These measures became urgent with the economic crisis, which has triggered an increased number of bankruptcy proceedings and overburdened the commercial courts.
C. RELATIONSHIP TO OTHER BANK OPERATIONS 86. The proposed ERDPL is supplemented by analytical and advisory services focusing on labor markets, social protection and governance, as well as by the investment lending activities in the social welfare, health, finance and judicial areas. This includes the following investment operations:
• The Social Welfare Development Project (SWDP) was approved by the World Bank Board in 2004. In particular, the SWDP contributes to wider participation in economic growth by improving the quality and efficiency of social services. The SWDP design was based on the National Program for the Reduction of Poverty, which was adopted by the Government in August 2002 and which proposes a multidimensional approach to the poverty reduction through measures that are not limited to the social welfare system only, but also include actions in the areas of labor market, employment, education, health and housing.
• The Development of Emergency Medical Services and Investment Planning project, approved in September 2008, supports, among others, supply-side reforms by developing restructuring plans for health care facilities and human resources through the development of a health facilities master plan.
30
• The Croatia Export Finance Intermediation Loan was approved by the Board in August 2009 and supports the Government’s objective to maintain a steady flow of credit to the private sector and assist in enhancing its competitiveness.
• The Justice Sector Support Project was approved by the Board in March 2010 and aims to improve the efficiency of the court system and the State Attorney’s Office, strengthening the management functions of the Ministry of Justice and supporting the enforcement reform.
D. LESSONS LEARNED 87. A number of important lessons relevant for the design of the proposed ERDPL emerged from the Implementation Completion and Results Report (ICR) for the Fiscal, Social and Financial Sector DPL that was completed in August 2010, and provides an overall satisfactory rating to the operation. The DPL was closely aligned with the Government’s crisis-mitigation program in fiscal, social and financial sectors. The efforts focused largely on short-term measures that aimed to protect macroeconomic and social stability. At the same time, some measures contributed to addressing the medium-term agenda in public financial management and financial sector regulation.
88. One of the lessons highlighted by the ICR is that fiscal consolidation and recovery from crisis take time and therefore focusing on a medium-term reform agenda would be warranted. Financing through higher taxes do damage to incentives, including keeping the grey economy large and, therefore, fiscal consolidation is not a one-off process but one that demands attention of policy makers for years. Policy actions supported by a Fiscal, Social and Financial Sector DPL are only a small step in the longer term process of fiscal consolidation. Furthermore, Croatia is in a tough fiscal position for a number of reasons – including the impact of recession, limited monetary policy space to accelerate recovery in a heavy euroized economy, and due to long-delayed structural reforms that weakened country’s long-term growth potential. Thus, in order to boost competitiveness and put future growth on a more sustainable footing, a follow-up budget support operation was recommended to be focused on the medium- to long-term reform measures.
89. Another lesson from the past operation is that having a limited scope of the operation, all prior actions completed ahead of the Board, and all funds disbursed in one tranche is less risky than moving forward with a comprehensive program with stretch goals. In a situation in which there is already steady pressure to reform in order to gain EU accession, this approach makes sense.
E. ANALYTICAL UNDERPINNINGS 90. The proposed ERDPL is based on a series of economic and sector work on Croatia. This includes the following analysis:
• Restructuring Public Finance to Sustain Growth and Improve Public Services - Public Finance Review (PFR, February 2008): The PFR analyzed Croatia’s fiscal consolidation challenges given the country’s EU accession efforts, and explored the ways to increase public sector efficiency in the areas of transport, environment, education, health, pensions, social benefits as well as in public administration and state subsidies. It also offered recommendations on strengthening public finance management.
• Regional Study on Performance Based Budgeting (October 2008): The study reviewed public finance management practices of selected countries in Central Europe, including Croatia. It included recommendations for strengthening program and medium-term budgeting and underlined that reform of public financial management (PFM) practices to ensure efficiency and effectiveness of public spending has become increasingly important at a time of crisis.
• Croatia’s EU Convergence Report – Reaching and Sustaining Higher Rates of Economic Growth (June 2009): The report focuses on the key policy recommendations for sustainable
31
growth acceleration. It suggests a set of measures around the so-called “Lisbon Agenda” that appear to be both feasible and sufficient to build the foundations for higher and sustained rates of economic growth. Those related to improving the efficiency and effectiveness of the labor market and social system are providing the highest rate of return, but are clearly politically most demanding.
• Social Impact of the Crisis and Building Resilience (July 2010): This report, done jointly with the UNDP, assessed the social impact of the crisis in Croatia, assessed the efficiency of labor market and social safety net programs to address emerging issues; and recommended measures to improve their efficiency. As part of this task, an update of the poverty assessment was undertaken.
• Policy Notes on fiscal responsibility, pensions and labor market: Informal analytic work on labor market issues, fiscal responsibility frameworks and pension sector reform is ongoing and guiding the design of several ERDPL components.
V. THE PROPOSED ECONOMIC RECOVERY DEVELOPMENT POLICY LOAN (ERDPL)
A. OPERATION DESCRIPTION 91. Objective and Reform Areas: The objective of the proposed ERDPL series is to support economic recovery. The program supported is built on two pillars: (i) enhancement of fiscal sustainability through expenditure-based consolidation; and (ii) fostering private sector growth. The measures supported are in line with the policy actions in the Government’s Economic Recovery Program. Because a sound medium-term macroeconomic framework is a prerequisite for Bank’s budget support, the Bank closely coordinates macroeconomic assessments with the IMF.
92. This series of two single-tranche ERDPLs focuses largely on medium-term measures that aim to safeguard macroeconomic stability through reforms in public administration, public finance and social sectors, and support economic recovery through labor market, privatization, innovation policy and investment climate reforms. The key outcome indicators that this program is expected to contribute to, in addition to many other factors outside the program which impact the results, are the following:
• General Government spending reduced from 43.2 percent of GDP in 2010 to 40.9 percent of GDP in 2012;
• The general Government wage bill reduced from 10.7 percent of GDP in 2010 to 9.9 percent of GDP in 2012;
• Total public health spending reduced from 6.9 percent of GDP in 2010 to 6.2 percent of GDP in 2012;
• Social benefit spending reduced from 2.6 percent of GDP in 2010 to 2.3 percent of GDP in 2012;
• Pension spending reduced from 10.5 percent of GDP in 2010 to 9.7 percent of GDP in 2012;
• The labor force participation rate (15-64) increased from 62.4 percent in 2009 to 64 percent in 2012;
• The institutions score (from Global Competitiveness Index) increased from 3.6 in 2010-2011 to 3.9 in 2012;
• The private sector share in GDP increased from 70 percent in 2009 to 75 percent in 2012; • Research and development spending increased from 0.8 percent of GDP in 2009 to 1.1
percent in 2012.
32
93. Table 6 summarizes the pillars (broad policy areas), reform areas and key actions covered under each of them for ERDPL1. The specific reforms supported in each area are described in the following sections; in the Government’s Letter of Development Policy (Annex 1); and the ERDPL policy matrix (Annex 2). These reform efforts are in line with the medium-term reform agenda laid out in Government’s strategic documents, supported by the dynamics of EU integration and the broad consultative/consensus building processes. The program remains fairly ambitious, but has been designed as such at the request of the Government which emphasized its capacity to focus on a broad set of issues and the reform momentum of the pre-accession period to advance the reform agenda.
Table 6: Summary of the Proposed Reform Program and the ERDPL1 Actions Pillar Objectives Reform Areas Policy actions Enhancing fiscal
sustainability through expenditure-based
consolidation
More credible, transparent and sustainable fiscal policy
• The Borrower has introduced temporary fiscal rule through enactment of the Law on Fiscal Responsibility; and established the Fiscal Board through Government Decision.
Fiscally more affordable public administration that meets EU standards related to merit and professionalism
• The Borrower has submitted the draft amendments to the Civil Service Act to the Parliament aiming at strengthening the appraisal system and disciplinary measures, and has established the HRMIS through enactment of the Law on Registry of Public Employees.
Increased efficiency of health financing
• The Borrower has streamlined co-payment exemptions through amendments to the Act on Complementary Health Insurance, reduced drug costs through the adoption of two ordinances, and launched hospital network rationalization through the adoption of the Public Health Insurance Network revision.
Cash social benefit spending contained, spending focused on best-targeted programs, and the administrative system rationalized.
• The Borrower has adopted the Social Welfare Strategy and submitted the draft Social Welfare Act to Parliament, aiming at consolidating benefits, improved targeting of social benefits, and rationalizing the social welfare administrative network.
Improved fiscal and social sustainability of the pension system.
• The Borrower has reduced privileged pensions by 10 percent through enactment of the Law on Reducing Pensions Determined or Earned According to Special Regulations on Pensions Insurance, has increased the minimum service to one parliamentary term through enactment of amendments to the Law on Rights of Members of the Parliament and has submitted to the Parliament draft amendments to the Law on Rights of Members of the Parliament aiming at increasing retirement age for Government Officials, MPs and Constitutional Court Judges.
• The Borrower has equalized retirement age for men and women at 65, and doubled the early retirement penalty through enactment of the Obligatory Pension Insurance Act, and has reduced administrative costs in funded pension pillars through HANFA Decision.
Fostering private-sector growth
Increased labor market flexibility and incentives for active job search
• The Borrower has reduced unemployment benefit and its duration, and reduced pre-retirement unemployment benefit duration to five (5) years through the enactment of the amendments to the Employment Intermediation and Unemployment Benefit Act.
Reduced administrative and regulatory barriers to business
• The Borrower has accelerated enforcement of commercial disputes resolution through the enactment of the Laws on Enforcement, Bailiffs and the Execution of Cash Assets.
Reduced state involvement in the enterprise sector through privatization or liquidation of state-owned enterprises
• The Borrower has strengthened institutional framework for management of state property and its privatization through the enactment of the Law on State Property Management; and has sold/liquidated at least 100 state-owned companies.
33
94. In many of these areas, while not supported in the ERDPL1 as prior actions, the Government is in the process of articulating further measures consistent with their broader medium term agenda as described in Box 2 (in some cases these are being developed through the Bank’s AAA program such as the high education technical assistance). These are summarized in the Letter of Development Policy (Annex 1) and the Policy Matrix (Annex 2) under the ERDPL2 column.
B. POLICY AREAS POLICY AREA I: ENHANCING FISCAL SUSTAINABILITY THROUGH EXPENDITURE-
BASED CONSOLIDATION 95. The proposed reforms will improve the predictability of public spending, and strengthen the short- and medium-term sustainability of public finances. To safeguard macroeconomic stability, the ERP proposed expenditure-led fiscal consolidation that would require undertaking social sector (pensions, health and social benefits) and public administration reforms. The reforms proposed to be supported under the ERDPL series focus on the adoption of the Fiscal Responsibility Law (FRL) where the objective is to anchor the medium-term expenditure-reduction target of one percentage point of GDP per year in a credible, predictable and enforceable legal framework. In the area of public administration, the objective is to support public administration rationalization and at the same time support merit-based principles of the public pay system to enhance its capacity to attract and retain critical skills in public administration. The health and social welfare sector measures seek to contain the spending and clear arrears, while improving efficiency and equity of service provision. The pension sector measures aim to improve the long-term sustainability of the pension system as well as enhance fairness.
96. Fiscal Responsibility Framework:
• ERDPL1: The Borrower has introduced temporary fiscal rule through enactment of the Law on Fiscal Responsibility; and established the Fiscal Board through Government Decision;
• ERDPL2: Amendments to the Fiscal Responsibility Act enacted to strengthen the permanent fiscal rule as necessary, based on the effectiveness analysis of the current fiscal responsibility framework.
97. Public Administration Reform:
• ERDPL1: The Borrower has submitted the draft amendments to the Civil Service Act to the Parliament aiming at strengthening the appraisal system and disciplinary measures, and has established the HRMIS through enactment of the Law on Registry of Public Employees;
• ERDPL2: A new Law on Unified Public Administration Salaries enacted, promoting provisions for decompression and performance-based remuneration.
98. Increased Efficiency of Health Financing:
• ERDPL1: The Borrower has streamlined co-payment exemptions through amendments to the Act on Complementary Health Insurance, reduced drug costs through the adoption of two ordinances, and launched hospital network rationalization through the adoption of the Public Health Insurance Network revision;
• ERDPL2: Pharmaceutical expenditures further rationalized through the national implementation of e-prescriptions, the standardization and classification of medical technology and orthopedic devices; and means-testing applied to health co-payment exemptions for social categories of insurers.
34
99. Social Welfare Reform:
• ERDPL1: The Borrower has adopted the Social Welfare Strategy and submitted the draft Social Welfare Act to Parliament, aiming at consolidating benefits, improved targeting of social benefits, and rationalizing the social welfare administrative network;
• ERDPL2: Means-testing broadened to other social assistance programs.
100. Pension System Equity and Financial Sustainability:
• ERDPL1: (i) The Borrower has reduced privileged pensions by 10 percent through enactment of the Law on Reducing Pensions Determined or Earned According to Special Regulations on Pensions Insurance, has increased the minimum service to one parliamentary term through enactment of amendments to the Law on Rights of Members of the Parliament and has submitted to the Parliament draft amendments to the Law on Rights of Members of the Parliament aiming at increasing retirement age for Government Officials, MPs and Constitutional Court Judges; and (ii) The Borrower has equalized retirement age for men and women at 65, and doubled the early retirement penalty through enactment of the Obligatory Pension Insurance Act, and has reduced administrative costs in funded pension pillars through HANFA Decision;
• ERDPL2: (i) Special pensions fully converged closer to PAYG system; and (ii) Administrative cost in funded pension pillars further reduced, second pillar contribution rate increased and basic pension revised through Act on Voluntary and Obligatory Pension Funds and amendments to the Obligatory Pension Insurance Act.
POLICY AREA II: FOSTERING PRIVATE-SECTOR GROWTH 101. The proposed reforms aim to support a dynamic private sector after the economic crisis through improved business environment and reduced state involvement in the corporate sector. The reforms proposed to be supported under the ERDPL series focus on the adoption of the new Employment Intermediation and Unemployment Benefit Act, Labor Act, Action Plan for Elimination of Administrative Barriers, and a set of laws to speed up enforcement and bankruptcy procedures. The objective of these reforms is to allow for faster entry and exit of productive/unproductive firms, faster mobilization of labor resources, and increased business sector competitiveness. The reinvigoration of the privatization process aims to attract private capital for the restructuring of troubled state-owned firms, and pull the state out of commercial business in sectors for which there is already strong competition. Additionally, strengthening the innovation framework would contribute to competitiveness of the economy. The specific measures agreed under the ERDPL series are:
102. Labor Market Flexibility and Incentives for Active Job Search:
• ERDPL1: The Borrower has reduced unemployment benefit and its duration, and reduced pre-retirement unemployment benefit duration to five (5) years through the enactment of the amendments to the Employment Intermediation and Unemployment Benefit Act;
• ERDPL2: Amendments to the labor law enacted to increase working hours’ flexibility, employment and wage flexibility, and lower layoff costs and notice.
103. Reducing Administrative and Regulatory Barriers to Business:
• ERDPL1: The Borrower has accelerated enforcement of commercial disputes resolution through the enactment of the Laws on Enforcement, Bailiffs and the Execution of Cash Assets;
35
• ERDPL2: Reduced duration of land registration through the implementation of Joint Information System in land registration and cadastre.
104. Accelerated Privatization Process:
• ERDPL1: The Borrower has strengthened institutional framework for management of state property and its privatization through the enactment of the Law on State Property Management; and has sold/liquidated at least 100 state-owned companies;
• ERDPL2: At least 200 state-owned companies brought to the point of sale/liquidation.
105. Strengthening innovation framework:
• ERDPL2: A Science Act and the new Universities Act enacted to increase the collaboration of businesses and the public sector and efficiency of investments into science.
VI. OPERATION IMPLEMENTATION
A. POVERTY AND SOCIAL IMPACT 106. Crisis led to a rise in poverty in Croatia. While the rise in the headcount poverty rate38
Table 7: Consumption Poverty in Croatia, 2008 -2011
in 2009 was only marginal according to official data, micro-simulations based on the 2009 Household Budget Survey suggest that the poverty incidence increased substantially in 2010 and 2011. The poverty rate in 2011 is projected at 14 percent, 4 percentage points up from 2009. Almost the entire four percentage points’ rise in the poverty headcount was due to deterioration in living standards as job losses and real wage reduction depressed household consumption. The impact of new policies is largely assessed to remain confined to the upper quintiles.
Notes: The anchored poverty line approach is applied. The poverty line is set at equivalent consumption level of the first decile in 2008 and adjusted with inflation for subsequent years. Due to various recall periods for expenditures in the HBS and because the survey is conducted continuously throughout the year, the central point of observation is April of each year. Source: Staff estimated based on the 2008 and 2009 HBS. Projections are based on the 2009 HBS
107. The model developed to simulate the impact of the ERDPL-supported reforms incorporates several policy changes aimed at maintaining macro stability which have important distributional impacts. These include: (i) the reduction in co-payment exemptions; (ii) the reduction in the unemployment benefit and its duration; and (iii) the reduction in privileged pensions. The simulation approach is similar to that used in the 2010 Social Impact of the Crisis and Building Resilience report39
108. While some measures supported by the ERDPL1 have distributional impacts, their impact on the poor has been partially mitigated by exemptions for lower income households. In
.
38 Given that the central point of observation in the Household Budget Survey (HBS), the basis for the poverty estimation, is April, poverty data for 2009 capture the effects of the first several months of the crisis. 39 2010 World Bank, Croatia: Social Impact of the Crisis and Building Resilience.
Estimates Projections 2008 2009 2010 2011
Poverty headcount rate (%) 10.0 10.4 12.6 14.0 Poverty gap (%) 2.2 2.4 3.2 3.9 Squared poverty gap (%) 0.8 0.9 1.4 1.8
36
particular, health co-payments are waived for adults earning less than HRK 1,516 a month40
Table 8: Impact of Selected Policy Reforms on Poverty
(or 1,939 HRK a month per single-elderly) or belonging to vulnerable categories (students; people with disabilities). Rationalization of co-payment exemptions is expected to suppress the household consumption on average by around 0.08 percent. A cut in privileged pensions by 10 percent or the abolishment of personal tax income allowances did not affect the low-income groups either. The reduction in privileged pensions and the freeze of nominal pensions are expected to reduce household income by 0.2 percent, with a stronger impact on the wealthier households. Both pension and the social welfare reform aim to improve the prospects for eradication of extreme poverty by protecting the relative value of the poverty benefit, limiting the errors of exclusion as well as increasing pension benefits for women in particular by incentivizing them to stay longer at the labor market and thus generate higher benefits at the time of retirement.
Policy measure Impact on reduction of income/consumption
Increase/decrease of poverty
Reduction of co-payment exemptions
-0.08% (decrease of average consumption per equivalent adult)
0.06% (poverty rate increase without the reform poverty rate at 13.96; with the reform at 14.02%)
Unemployment benefit reform neutral (due to increase of the benefit for first three months and reduction thereafter; shortening of the benefit duration, but allowed extended unemployment benefit duration for vulnerable)
neutral
Privileged pension reform -0.2% (decrease of average consumption per equivalent adult)
0.07% (poverty rate increase)
PAYG system reform short-term impact negligible; long-term positive with longer service yielding higher pension benefits for women, and discouraged early retirement yielding higher pensions
short-term impact negligible; long-term positive with poverty rate declining for women and in general due to higher pension benefits
Social welfare reform (indexation to 22.5% of relative poverty line)
immediate impact neutral; medium-term positive impact with rise in income of the poor
immediate impact neutral, long-term impact suggest eradication of extreme poverty
Source: Staff estimated based on the 2009 HBS.
109. In spite of policy efforts to limit negative distributional effects of the crisis, the success was only partial mostly due to unfavorable labor market developments. For the poorest decile, household income is projected to decline by around five percent in 201141
40 The first decile income threshold is set at HRK1,000 per equivalent adult per month.
due to increased unemployment and, importantly, due to the discontinuation of unemployment benefits for those who remain unemployed for a longer period. It appears that the prolonged recession has increasingly negative impact on the poorest population. For the second decile, as well as the remaining population, the negative labor market developments are expected to decline income by about 2 percent. While the suspension of the pension indexation in 2010 protected real pensions from a reduction in the cost of
41 Between April 2010 and April 2011.
37
living and the fall in real incomes, this measure will likely lead to some rise in the poverty headcount among pensioners in 2011. Under the assumption of an increase in the cost of living by 2.5 percent, the poverty headcount among pensioners will go up from an estimated 16 percent in 2010 to 17.5 percent in 2011 (assuming that all other policies remain unchanged). This necessitates the return to regular indexation mechanism to protect the deterioration of real pensions as soon as the fiscal situation allows.
110. The social welfare reform, that among other things aims to improve targeting and is supported under this operation, is expected to mitigate the impact on the most vulnerable. The proposed reforms are expected to protect the funding and facilitate the access to means-tested programs. Some of these mitigation measures notwithstanding, the Government can expect an increase in the number of claimants for social welfare benefits and services, as the crisis got prolonged.
111. The information base for poverty monitoring is scarce in Croatia, although there are attempts to improve the quality and representativeness of the data. In addition to two regular surveys (Household Budget Survey, Labor Force Survey) conducted to monitor living conditions and labor market outcomes of households, CROSTAT is introducing a new one in 2011 – Survey on Income and Living Conditions, which should provide more comprehensive, EUROSTAT-harmonized and more frequent data on incomes and living conditions of households. The new census to be carried out in 2011 will also improve representativeness of the sample of households, which over the last couple of years eroded substantially.
B. ENVIRONMENTAL ASPECTS 112. The proposed support to the budget and policy reforms has been screened against OP 8.6. and the screening neither show any direct linkages to the environment nor suggests that the proposed policy reforms will have significant environmental impacts; however the support to some of the reforms might have an indirect impact on the implementation of the environmental legislation in Croatia. The ERDPL supported the implementation of the new network of health institutions that establishes the number of health institutions and health workers required. The changes will not directly affect environment, as the management of medical waste is covered by sub-legislation on waste issued and will apply to potential newcomers. The number of accredited laboratories in charge of monitoring the quality of drinking water (mainly carried out by the Croatian National Institute of Public Health) will remain the same, although management of some institutions might be
Figure 6: Projected Change in Net Disposable Household Income in 2011, in real terms
Figure 7: Projected Poverty by Household Head's Status of Employment
Note: Impact of labor market development and policy interventions. The anchored poverty line applied. Source: CROSTAT, staff projections based on the 2009 HBS.
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
1st decile 2nd decile 2nd-5th quintile
Labor market impact Abolishment of the crisis tax Changes in income taxationPrivileged pensions cut Health insurance premium OtherTotal
0
5
10
15
20
25
30
35
40
45
Employed Self-Employed(Non-farm)
Self-employedFarmers
Unemployed Retired Other Inactive
2009 2010p 2011p
Poverty headcount rate (%)
38
consolidated.
113. The planned rationalization of public administration will also impact staffing of the MEPPPC and other relevant ministries in charge for environment. However, predefined evaluation criteria and procedure will ensure that more competent and professionally trained staff will be retained in the relevant ministries. The cuts in the ministries should also be done in accordance with the amendments to the regulation on the internal organization of the Ministry of Environmental Protection, Physical Planning and Construction (OG 12/09) and plan for establishment of required administrative capacities at the national, regional and local levels and required financial resources for the implementation of the environmental acquis. The preparation of the plan was an EU negotiation benchmark on opening the negotiations on Chapter 27 - Environment.
114. The access to justice in environmental matters is still weak, and strengthening this segment is necessary. The overall number of prosecutions of environment cases remains low. The strengthening of independency, impartiality and efficiency in judiciary together with the accelerated enforcement system might lead to improvements in this case. The regulation on internal organization of the MEPPPC has also established the Directorate for Legal Affairs of Inspectional Supervision for the purpose of providing support for the performance of inspectional supervision activities, which might lead to improved prosecution of cases.
115. The acceleration of the privatization and bankruptcy process will not directly tackle environmental liability issues, as the privatization act does not cover environmental liability issues. Nevertheless, the Environmental Liability Directives has been transposed into the Croatian legislation and ‘polluter pays’ principle applies. As this is the recent legislation, the implementation and effectiveness of the system is yet to be seen.
116. Overall legislative framework on environment: Croatia continues making considerable and sustained efforts to align its legislation with the acquis and to effectively implement and enforce it in the field of environment in the medium term. Significant progress has been made. The most significant step has been the adoption of the new Law on Environment in 2007 in line with the EU environmental acquis. The new law introduces strategic environmental assessment (SEA), strengthens public access to environmental information and environmental liability, and includes provisions of the SEVESO II and IPPC directive. Basic EIA competence remains high and is further strengthened by the adoption of the new Law on the Environmental Protection, and secondary Environmental Impact Assessment (EIA) legislation, which achieved full alignment with EIA Directive (85/337/EEC). Regulation on EIA introduces the procedure for evaluation of the need for environmental impact assessment (screening) and decentralization of EIA process transferring certain types of projects to county administrative bodies. In the latest EU 2010 Progress Report, harmonization with the EU environmental acquis is assessed positively which implies that the current legislation could serve as a good safeguard mechanism for measures supported by the ERDPL.
C. IMPLEMENTATION, MONITORING AND EVALUATION 117. Coordination of Reform Program Implementation: Successful implementation of the proposed reform program will require effective coordination among various ministries and agencies, and between the Government and the Bank. The Government assigned the Minister of Finance to coordinate the ERDPL agenda within the Government with the technical assistance of the MoF’s IFI Department. The Government, led by the Prime Minister, will oversee the whole reform effort and ensure prompt action on agreed reforms.
118. Bank’s Monitoring Arrangements: The reform program sets out qualitative and quantitative benchmarks and program targets. The Bank team monitors and follows up on progress, and meets with Croatian authorities periodically to discuss next steps.
39
D. FIDUCIARY ASPECTS 119. Public Financial Management System: After the 2005 Country Financial Accountability Assessment (CFAA)42
120. Croatia has also made some progress in government budget transparency, although further improvements would be welcome. Croatia’s score on the Open Budget Index for 2010 shows that the Government provides the public with some information on the central Government’s budget and financial activities during the course of the budget year. Croatia publishes detailed semi-annual reports allowing comparisons between what was budgeted and what was actually collected and spent. It is, however, still difficult to track spending, revenue collection and borrowing during the year on a timely basis. Croatia makes its audit report public; however, it provides limited information on whether the audit report’s recommendations are successfully implemented. There has been some progress with external audit in Croatia, which generally meets the requirements of INTOSAI auditing standards. A long-term development strategy has been adopted and the SAO (State Audit Office) has formally adopted the INTOSAI and developed tools such as audit manuals. Croatia closed EU accession negotiations of Chapter 32 Financial Control in July 2010, that among else seeks a full functional and financial independence of the SAO.
concluded that the level of fiduciary risk to Croatia’s public financial management systems was significant; Croatia has taken actions to improve the public financial management system which have been supported by the World Bank PAL program and the EU. The authorities have established internal audit units in all line ministries, central state organizations, extra-budgetary funds and selected local governments. The Law on Financial Management and Control Systems in the Public Sector was enacted in 2008 and controllers were appointed for all line ministries. The consolidation of line ministries and EBFs accounts under the Single Treasury Account improved cash and debt management as well as budget planning system.
121. On the accounting and reporting, there is a broad compliance with the IPSAS standards for the public sector, but in practice budgeting and the approved state budget as well as reporting and monitoring of the budget are done on a cash basis. However, accounting of ministries and other budget users is carried out on a modified accrual basis whereby revenues are recorded when cash has been received and expenditures are recognized when an invoice has been received. The Government Financial Management and Information System (FMIS) is being developed and improved, and it is expected to contribute to the harmonization of the Treasury’s financial management information system with the systems available in budget-users by creating adequate interfacing and allowing data exchange and inter-operability.
122. The budget execution process has been steadily strengthened. The treasury single account now includes all line ministries and the major extra budgetary funds such as health, pensions and employment, although the proposal went to the Parliament to exclude the health insurance fund from the TSA from January 2012. Reports on TSA balances, inflows and outflows are available on a daily basis to the MoF and budget users enabling close monitoring of the budget implementation.
123. The 2010 EC Progress Report for Croatia noted the progress achieved in the fight against corruption, although the score at the Transparency International corruption perception index for Croatia declined to score of a 4.1 in 2010 and 2009, compared to the score of 4.4 in 2008. The progress noted relates to improved legal framework to combat organized crime and corruption; anti-corruption measures and ethical principles embedded in public administration; and improved provisions for confiscation of assets. Series of investigations and indictments of economic and organized crime have been launched in almost every sector of public interests.
42 Apart from the CFAA, several recent external reports have been consulted to review the actions taken to improve the public financial management system and to present the current reform status.
40
124. The fiduciary risk associated with public financial management system is thus improved to moderate. The public finance management framework provides solid basis for the Bank’s increased use of country systems, supported by stable development in portfolio financial management and financial performance over the last years. Harmonization with the EU, both in legislation and in practice, has advanced, though various budgetary functions require further development. Country systems for financial management are used in several Bank-funded projects, including for audits, since the State Audit Office meets the auditing standards required for Bank-funded projects.
125. Since the Country Procurement Assessment Report (CPAR) was finalized in 2005, the level of risk in public procurement remained moderate. Since then, consistent with the CPAR recommendations, the legislative framework and institutional capacity of the Public Procurement Office (now Directorate for Public Procurement System) and the State Commission for Monitoring Public Procurement have been strengthened with assistance from the EC, and these entities have taken the lead in procurement reform in Croatia. A Public Procurement Law aligned with the EU Directives became effective in January 2008, with subsequent amendments in October 2008, leading to increased transparency and improvements in the fiduciary environment. Standard tender forms, manuals for tenderers and contracting authorities have been developed and posted on the public procurement portal, together with other strategic documents concerning public procurement. The portal is updated regularly and selected key documents are available in English language. In April 2009, the Government adopted a Regulation on the format, method, conditions of training and certification in the public procurement system. The Department for the Public Procurement System (DPPS) in the Ministry of Economic Affairs and Entrepreneurship (MELE) continues its consistent work in ensuring the efficient implementation of the public procurement policies and the Strategy for the Development of the Public Procurement System. The Public Procurement law and the relevant implementing legislation are aligned with the acquis, which is also confirmed by the closure of EU accession negotiations on Chapter 5 in June 2010.
126. Safeguards Assessment of the Central Bank: Three reports have been conducted on the Croatian National Bank (CNB) by the IMF and the IBRD so far. The Report on the Observance of Standards and Codes of Fiscal Transparency, which was completed by the IMF in November 2004, concluded that the Croatian National Bank (CNB) has operational independence and that its financial relationship with the Government is transparent. The IMF finalized a safeguards assessment of CNB in 2006, and concluded that the safeguards are adequate and that the CNB continues to maintain an effective system of internal controls and almost all areas of the safeguards meet the policy’s requirements, though the internal audit mechanisms could be strengthened further. In 2008, a joint IBRD/IMF mission updated Financial System Assessment Report which outlined strong independence of the CNB, strengthened internal audit and risk assessment mechanisms. Croatia closed EU accession negotiations of Chapter 17 Economic and Monetary Policy, which among else requires a full CNB independence, in December 2008. CNB is audited by independent auditors every year and the 2009 audit report has unqualified opinion. Based on the above, CNB can be relied upon to account for the World Bank’s proceeds from development policy operations.
E. DISBURSEMENT AND AUDITING 127. Borrower and Loan Amount: The Borrower is the Republic of Croatia. This operation is a single-tranche loan in a series of two loans. The loan proceeds would be made available to the Borrower upon the effectiveness of the Loan Agreement between the Republic of Croatia and the Bank. As a condition of effectiveness, the Bank will have to be satisfied with the progress achieved by the Borrower in carrying out the Program and with the appropriateness of the Borrower’s macroeconomic policy framework.
128. Disbursement: Upon approval of the loan and notification by the Bank of the effectiveness of the Loan Agreement between the Bank and Croatia, the Borrower will submit a withdrawal
41
application to the International Bank for Reconstruction and Development (IBRD) before the closing date as provided in the loan agreement. The IBRD will deposit the proceeds of the loan into a foreign currency deposit account designated by the Borrower to be held at the CNB. This account forms part of the official foreign currency reserves of the country and it will be managed by and subject to control of the Ministry of Finance (MoF).
129. Accounting and Auditing Arrangements: The administration and accounting of the loan will be the responsibility of the MoF. The MoF will be responsible also for preparing the withdrawal application, and maintaining the withdrawal application as required. The MoF, with the assistance of CNB, will maintain records of all transactions under the loan in accordance with sound accounting practices. Given the positive IMF’s assessment of CNB, an audit of the deposit account for the proceeds of the loan is not considered necessary. The MoF will provide the Bank within 30 days a confirmation letter stating that the ERDPL funds have been received and deposited into the designated account assigned by the borrower that forms part of the Borrower’s budget management system.
F. RISKS AND RISK MITIGATION 130. The proposed ERDPL series has very high risks. The key risks are as follows:
131. Economic risks. Economic risks are substantial given Croatia’s prolonged recession and high external vulnerability. The key risk is that economic recovery in the EU and Croatia may be weaker than currently projected. Slower than projected growth in Croatia would further strain the fiscal stance, the corporate sector and consequently the banks, and could raise social tensions. Croatia’s heavy reliance on tourism revenues and exports to Europe makes it vulnerable to any deterioration in regional stability or slowdown of growth in the EU. Given the uncertain economic situation in some EU countries and volatility resulting from fears of contagion, the planned fiscal consolidation will be harder than previously thought. This could jeopardize the achievement of planned medium-term macroeconomic and social outcomes. Furthermore, high level of external debt, high degree of euroization of the Croatian economy and large debt service requirements over the medium term render the Croatian financial sector vulnerable to exchange rate risks and a slowdown in capital inflows. Refinancing of external obligations may thus become challenging.
132. Mitigation measures. The ERDPL-supported fiscal consolidation efforts are expected to mitigate the risks related to regular public debt servicing even in the case of a prolonged recession. In parallel, reforms supporting the private sector growth are expected to accelerate recovery in Croatia. The ERDPL team will continue to monitor financial sector performance.
133. Political risks. Political risks remain high. The country has a coalition Government with a slim majority in Parliament, while several proposed reforms are ambitious and politically challenging. The need to mitigate the impacts of recession and implement a fairly broad medium-term reform agenda in a difficult economic environment might strain the coalition, with an uncertain impact on the reform agenda. With general elections tentatively scheduled for late 2011, the country is entering a pre-election period which may raise the risk of unsound policies. High unemployment and increasing pressures from various social groups may reduce the already low social appetite for reforms, including for the labor market reform.
134. Mitigation measures. Most reforms proposed to be supported under the ERDPL are being implemented. Some are also part of EU accession negotiations, which is expected to mitigate the risk of reversal or delays. Given the recently announced timetable for the conclusion of EU accession negotiations by mid-2011, the momentum for reform is likely to be maintained.
42
Annex 1: Letter of Development Policy
43
44
45
46
47
Annex 2: Croatia ERDPL Policy Matrix Government's Reform Strategy (Policy Actions) and Progress Indicators (Outcomes and Outputs)
Medium-Term
Objectives
ERDPL 1 Policy Actions
ERDPL 2 Indicative Triggers
Indicators Baseline (Year)
Expected Outcomes
2011 2012
ERDPL COMPONENT I: ENHANCING FISCAL SUSTAINABILITY THROUGH EXPENDITURE-BASED CONSOLIDATION
A more credible, transparent and more sustainable fiscal policy
The Borrower has introduced temporary fiscal rule through enactment of the Law on Fiscal Responsibility; and established the Fiscal Board through Government Decision.
Amendment to the Fiscal Responsibility Act enacted to strengthen the permanent fiscal rule as necessary, based on the effectiveness analysis of the current fiscal responsibility framework.
General Government spending as % of GDP
43.2% (2010)
42.1%
40.9%
Fiscally more affordable public administration that meets EU standards related to merit and professionalism
The Borrower has submitted the draft amendments to the Civil Service Act to the Parliament aiming at strengthening the appraisal system and disciplinary measures, and has established the HRMIS through enactment of the Law on Registry of Public Employees.
A new Law on Unified Public Administration Salaries enacted, promoting provisions for decompression and performance-based remuneration.
Public sector wage bill as % of GDP
10.7% (2010)
10.5%
9.9%
Increased efficiency of health financing
The Borrower has streamlined co-payment exemptions through amendments to the Act on Complementary Health Insurance, reduced drug costs through the adoption of two ordinances, and launched hospital network rationalization through the adoption of the Public Health Insurance Network revision.
Pharmaceutical expenditures further rationalized through the national implementation of e-prescriptions, the standardization and classification of medical technology and orthopedic devices; and means-testing applied to health co-payment exemptions for social categories of insures.
Total public health spending as % of GDP
6.9% (2010)
6.5%
6.2%
48
Cash social benefit spending contained, spending focused on best-targeted programs, and the administrative system rationalized.
The Borrower has adopted the Social Welfare Strategy and submitted the draft Social Welfare Act to Parliament, aiming at consolidating benefits, improved targeting of social benefits, and rationalizing the social welfare administrative network.
Means-testing broadened to other social assistance programs.
Social benefit spending as % of GDP
2.6% (2010)
2.5% 2.3%
Improved fiscal and social sustainability of the pension system.
The Borrower has reduced privileged pensions by 10 percent through enactment of the Law on Reducing Pensions Determined or Earned According to Special Regulations on Pensions Insurance, has increased the minimum service to one parliamentary term through enactment of amendments to the Law on Rights of Members of the Parliament and has submitted to the Parliament draft amendments to the Law on Rights of Members of the Parliament aiming at increasing retirement age for Government Officials, MPs and Constitutional Court Judges. The Borrower has equalized retirement age for men and women at 65, and doubled the early retirement penalty through enactment of the Obligatory Pension Insurance Act, and has reduced administrative costs in funded pension pillars through HANFA
Special pensions converged closer to PAYG system. Administrative cost in funded pension pillars reduced, second pillar contribution rate increased and basic pension revised through Act on Voluntary and Obligatory Pension Funds and amendments to the Obligatory Pension Insurance Act.
Pension spending as % of GDP
10.5% (2010)
10.2% 9.7%
49
Decision.
ERDPL PILLAR II: FOSTERING PRIVATE-SECTOR GROWTH
Increased labor market flexibility and incentives for active job search
The Borrower has reduced unemployment benefit and its duration, and reduced pre-retirement unemployment benefit duration to five (5) years through the enactment of the amendments to the Employment Intermediation and Unemployment Benefit Act.
Amendments to the labor law enacted to increase working hours’ flexibility, employment and wage flexibility and lower layoff costs and notice.
Labor force participation rate (15-64)
62.4% (2009)
63%
64%
Reduced administrative and regulatory barriers to business
The Borrower has accelerated enforcement of commercial disputes resolution through the enactment of the Laws on Enforcement, Bailiffs and the Execution of Cash Assets.
Reduced duration of land registration through the implementation of Joint Information System in land registration and cadastre.
Institutions (Score in Global Competitiveness Index)
3.6 (2010-2011)
3.7 3.9
Reduced state involvement in the enterprise sector through privatization or liquidation of state-owned enterprises
The Borrower has strengthened institutional framework for management of state property and its privatization through the enactment of the Act on State Property Management; and has sold/liquidated at least 100 state-owned companies.
At least 200 state-owned companies brought to the point of sale/liquidation.
Private sector share in GDP
70 (2009)
72 75
Strengthened innovation framework
A Science Act and the new Universities Act enacted to increase the collaboration of businesses and the public sector and efficiency of investments into science.
Research and development spending as % of GDP
0.8% (2009)
0.9% 1.1%
50
Annex 3: Fund Assessment Note
51
52
53
54
Dunay (Danube)
BOSNIA ANDBOSNIA ANDHERZEGOVINAHERZEGOVINA
HUNGARYHUNGARY
SLOVENIASLOVENIA
AUSTRIAAUSTRIA
MONTENEGROMONTENEGRO
To To TriesteTrieste
To To LjubljanaLjubljana
To To LjubljanaLjubljana
To To LjubljanaLjubljana
To To GrazGraz
To To ZalaegerszegZalaegerszeg
To To KaposvarKaposvar
To To PecsPecs To To
PecsPecs
To To BajaBaja
To To SomborSombor
To To SomborSombor
To To TuzlaTuzla
To To DobojDoboj
To To DobojDoboj
To To Banja LukaBanja Luka
To To PrijedorPrijedor
To To BihacBihac
To To BihacBihac
To To GlamocGlamoc
To To LivnoLivno
To To MostarMostar
To To MostarMostar
To To TrebinjeTrebinje
To To Novi SadNovi Sad
To To RumaRuma
DinaraDinara(1830 m)(1830 m)
Mljet Mljet
Korcula Korcula
Hvar Hvar
Vis Vis
Brac Brac
PagPag
KrkKrk
PasmanPasman
Peljesac Peljesac
SSaavvaa
VUKOVARSKO-VUKOVARSKO- SRIJEMSKA SRIJEMSKA
BRODSKO-BRODSKO-POSAVSKAPOSAVSKA
POZESKO-SLAVONSKAPOZESKO-SLAVONSKA
VIROVITICKO-VIROVITICKO-PODRAVSKAPODRAVSKA
BJELOVARSKO-BJELOVARSKO-BILOGORSKABILOGORSKA OSJECKO-OSJECKO-
BARANJSKABARANJSKA
SISACKO-MOSLAVACKASISACKO-MOSLAVACKA
KOPRIVNICKO-KOPRIVNICKO-KRIZEVACKA KRIZEVACKA
MEDIMURSKAMEDIMURSKA
VARAZDINSKAVARAZDINSKA
KRAPINSKO-KRAPINSKO-ZAGORSKAZAGORSKA
GRADGRADZAGREBZAGREB
ZAGREBACKAZAGREBACKA
ZAGREBACKAZAGREBACKA
KARLOVACKAKARLOVACKA
LICKO-LICKO-SENJSKASENJSKA
ZADARSKAZADARSKA
ISTARSKAISTARSKA
PRIMORSKO-PRIMORSKO-GORANSKAGORANSKA
SIBENSKO-SIBENSKO-
KNINSKAKNINSKA
SPLITSKO-SPLITSKO-
DALMATINSKADALMATINSKA
DUBROVACKO-DUBROVACKO-
NERETVANSKANERETVANSKA
IvanicIvanicGradGrad
NovskaNovska
DaruvarDaruvar
DurdevacDurdevac
DvorDvor
VinkovciVinkovci
StalijeStalije
KarlobagKarlobag
SenjSenj
UdbinaUdbina
KninKnin
VodiceVodice
TrogirTrogir
GracacGracac
SinjSinj
ImotskiImotski
MakarskaMakarska
JablanacJablanac
GlinaGlina
NasiceNasice
OtocacOtocac
SisakSisak
BjelovarBjelovarViroviticaVirovitica
KrapinaKrapina
VarazdinVarazdin
KoprivnicaKoprivnica
SlavSlavBrodBrod
OsijekOsijek
VukovarVukovar
CakovecCakovec
KarlovacKarlovac
GospicGospic
ZadarZadar
SplitSplit
SibenikSibenik
RijekaRijeka
PazinPazin
PozegaPozega˘̆
ZAGREBZAGREB
KKuuppaa
VUKOVARSKO- SRIJEMSKA
BRODSKO-POSAVSKA
POZESKO-SLAVONSKA
VIROVITICKO-PODRAVSKA
BJELOVARSKO-BILOGORSKA OSJECKO-
BARANJSKA
SISACKO-MOSLAVACKA
KOPRIVNICKO-KRIZEVACKA
MEDIMURSKA
VARAZDINSKA
KRAPINSKO-ZAGORSKA
GRADZAGREB
ZAGREBACKA
ZAGREBACKA
KARLOVACKA
LICKO-SENJSKA
ZADARSKA
ISTARSKA
PRIMORSKO-GORANSKA
SIBENSKO-
KNINSKA
SPLITSKO-
DALMATINSKA
DUBROVACKO-
NERETVANSKA
Porec˘
IvanicGrad
Novska
Daruvar
Durdevac
Dvor
Vinkovci
Stalije
Karlobag
Senj
Udbina
Knin
Vodice
Trogir
Gracac
Sinj
Imotski
Metkovic
Makarska
Ploce
Gruda
Jablanac
Pula
Glina
Nasice
Otocac
Sisak
BjelovarVirovitica
Krapina
Varazdin
Koprivnica
SlavBrod
Osijek
Vukovar
Cakovec
Karlovac
Gospic
Zadar
Split
Dubrovnik
Sibenik
Rijeka
Pazin
Pozega˘
ZAGREB
BOSNIA ANDHERZEGOVINA
HUNGARY
SLOVENIA
AUSTRIA
ITALY
MONTENEGRO
SERBIA
Sava Una
Kupa
Adriat icSea
To Trieste
To Ljubljana
To Ljubljana
To Ljubljana
To Graz
To Zalaegerszeg
To Kaposvar
To Pecs To
Pecs
To Baja
To Sombor
To Sombor
To Tuzla
To Doboj
To Doboj
To Banja Luka
To Prijedor
To Bihac
To Bihac
To Glamoc
To Livno
To Mostar
To Mostar
To Trebinje
To Podgorica
To Novi Sad
To Ruma
To Trieste
Mljet
Korcula
Hvar
Vis
Brac
Cres
Pag
Rab
Krk
Losinj
DugiOtok
Pasman
Peljesac
Dinara(1830 m)
14°E 15°E 16°E 17°E 18°E 19°E
14°E 15°E 16°E 17°E 18°E 19°E
42°N
43°N
44°N
45°N
46°N
43°N
44°N
45°N
46°N
CROATIA
IBRD 33394R1
JULY 2006
CROATIASELECTED CITIES AND TOWNS
COUNTY (ZUPANIJA) CAPITALS
NATIONAL CAPITAL
RIVERS
MAIN ROADS
RAILROADS
COUNTY (ZUPANIJA) BOUNDARIES
INTERNATIONAL BOUNDARIES
0 20 40
0 20 40 Miles
60 Kilometers
This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, o r any endo r s emen t o r a c c e p t a n c e o f s u c h boundaries.