Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 39641-HR

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

AND

INTERNATIONAL FINANCE CORPORATION

COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT

FOR

THE REPUBLIC OF CROATIA

FOR THE PERIOD FY05-FY08

May 7, 2007

South Central Europe Country Unit

Europe and Central Asia Region

International Finance Corporation

Southern Europe and Central Asia Department

The date of the last Country Assistance Strategy was December 21, 2004.

CURRENCY EQUIVALENTS

(Exchange rateas of April 24, 2007):

Currency Unit = Croatian Kuna (HRK)

US$1 = 5.455 HRK

GOVERNMENT’S FISCAL YEAR: January 1 – December 31

IBRD / IFC
Vice President:
Director:
Task Team Leader: / Shigeo Katsu
Anand K. Seth
Myla Taylor Williams / Edward Nassim
Shahbaz Mavaddat
George Konda

ABBREVIATIONS AND ACRONYMS

AAAAnalytical and Advisory Services
ARPPAnnual Review of Portfolio Performance
BEEPSBusiness Environment and Enterprise Performance
Survey
BICRO BusinessInnovationCenter of Croatia
CASCountry Assistance Strategy
CNBCroatian National Bank
CPFCroatian Fund for Privatization
CPIConsumer Price Index
CPPRCountry Portfolio Performance Review
CROSTATCentral Bureau of Statistics
DECDGDevelopment Economics, Development Data Group
DFIDDepartment for International Development
DRGDiagnostic Related Group
DSODistribution System Operator
EBRDEuropean Bank for Reconstruction and Development
ECEuropean Commission
ECAEurope and Central Asia
ESOPEmployee Stock Ownership Plan
EUEuropean Union
EU8EU New Member States as of May 1, 2004,
excluding Malta and Cyprus
EU8+2EU New Member States as of May 1, 2004,
excluding Malta and Cyprus, plus NewMemberStates as of January 1, 2007
EU15EU Member States prior to May 1, 2004
EU25EU Member States prior to January 1, 2007
EUROSTATStatistical Office of the European Communities
EUREuro is the currency of 13 European Union countries
ESDPEducation Sector Development Project
ESCOEnergy Service Company
FDIForeign direct investment
FIASForeign Investment Advisory Service
FSAPFinancial Sector Assessment Program
GDPGross Domestic Product
GEFGlobal Environment Facility
GMOsGenetically Modified Organisms
GNIGross National Income
GNPGross National Product
HANFAHrvatska agencija za nadzor financijskih usluga
(Croatian Financial Services Supervisory Agency)
HACHrvatske autoceste (Croatian Motorways)
HBORCroatian Bank for Reconstruction and Development
HCHrvatske ceste (Croatian Roads)
HDZCroatian Democratic Union
HEPHrvatska Elektroprivreda (Croatia’s national electric utility)
HIV/AIDSHuman Immunodeficiency Virus/Acquired Immunodeficiency Syndrome
HRHuman Resources
HRKCroatian Kuna
HROTEHrvatski operator trzista energije (Croatian Energy
Market Operator)
HZCroatian Railways
HZZOCroatian Institute for Health Insurance
IBRDInternational Bank for Reconstruction and Development
ICTInformation and Communication Technology
IDAInternational Development Association
IDFInstitutional Development Fund
IFAInstitutional Fiduciary Assessment / IFCInternational Finance Corporation
IFIInternational financial institution
ILOInternational Labor Organization
IMFInternational Monetary Fund
IPAInstrument for Pre-Accession Assistance
ISPAInstrument for Structural Policies for Pre-Accession
JPRJoint Portfolio Review
LGUsLocal Government Units
LSALiving Standards Assessment
MDG Millennium Development Goals
MIGAMultilateral Investment Guarantee Agency
MEPPPCMinistry of Environmental Protection, Physical
Planning and Construction
MoJMinistry of Justice
MoFMinistry of Finance
NATONorth Atlantic Treaty Organization
NPPNational Population Policy
NSRDNational Strategy for Regional Development
NTRBNeretva and TrebisnjicaRiver Basin
OECDOrganization for Economic Cooperation and Development
OED Operations Evaluation Department
OSCE Organization for Security and Cooperation in Europe
QPRQuarterly CAS Implementation Progress Review
PALProgrammatic Adjustment Loan
PEP-SEPrivate Enterprise Partnership – Southeast Europe
Infrastructure
PIUProject Implementation Unit
PISAOECD Program for International Student Assessment
PPIAFPublic-Private Infrastructure Advisory Facility
PPPPurchasing Power Parity
PPPPublic Private Partnership
PSDPrivate Sector Development
PSIAPoverty and Social Impact Assessment
PSRProject Status Report
RBIRudjer Boskovic Institute
R&DResearch and Development
ROPsRegional Operational Programs
ROSCReport on the Observance of Standards and Codes
RERenewable Energy
SAPARDSpecial Accession Program for Agriculture and Rural
Development
SBAStand-By Arrangement
SDFStrategic Development Framework
SEESouth East Europe
SEECSouth East European Countries
SIDASwedish International Development Agency
SMESmall and medium enterprises
SOEState-owned enterprise
SWDPSocial Welfare Development Project
TATechnical assistance
TBTuberculosis
TSOTransmission System Operator
UKUnited Kingdom
UNCCCFUN Framework Convention on Climate Change
UNDPUnited Nations Development Program
UNHCRUnited Nations High Commissioner for Refugees
USAIDUnited States Agency for International Development
USDUnited States dollar
VETVocational Education Training
WBGWorld Bank Group

COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT FOR

THE REPUBLIC OF CROATIA

TABLE OF CONTENTS

I.INTRODUCTION

II.COUNTRY CONTEXT

A.Political Developments

B.Economic Developments

C.Governance

D.Social Developments

III.RELEVANCE OF CAS

IV.FY07-FY08 CAS PROGRAM ADJUSTMENTS

A.Status of CAS Triggers

B.FY07-FY08 Scenarios and Triggers

C.Lending Volumes and IBRD Exposure

D.Priorities for World Bank Group Support

E.Managing External and Implementation Risks

Tables

In main text:

Table 1: Selected Medium-Term Macroeconomic Indicators

Table 2: Indicative IBRD Lending Program FY05-FY08

Table 3: IBRD Exposure Indicators for Base Case

Table 4: Complementarity between EU Accession Agenda and World Bank Group Program

In annexes:

Table A: Progress toward Achievement of Croatia CAS Country Development Goals

Table B: Croatia and the Millennium Development Goals

Figures

Figure 1: Economic Developments (2000-2006)

Figure 2: Selected Governance Indicators in 2005

Figure 3: Corruption Perception Index

Annexes

Annex A2: Country-at-a-Glance and MDGs

Annex B2: Selected Indicators of Bank Portfolio Performance and Management

Annex B3: IBRD/GEF Base Case Program Summary

Annex B3: IBRD/GEF High Case Program Summary

Annex B3: IBRD/GEF Low Case Program Summary

Annex B3: IFC and MIGA Program

Annex B4: Summary of IBRD Nonlending Services

Annex B6: Key Economic Indicators

Annex B7: Key Exposure Indicators

Annex B8: IBRD Operations Portfolio

Annex B8: IFC Committed and Outstanding Portfolio

Annex B9: CAS Results Matrix

Annex C1: Progress Towards CAS Outcomes and Milestones

Annex C2: CAS Program Delivery and Portfolio Management

Annex C3: Planned FY07-FY08 IBRD and GEF Programs and Linkages to EU’s Instrument for Pre-Accession Assistance (IPA)

1

CROATIA: COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT

I.INTRODUCTION

  1. The Board of Executive Directors discussed the FY05-FY08 Country Assistance Strategy for Croatia (CAS) on December 21, 2004 (Report No. 30717-HR). This paper assesses the relevance of the CAS, takes stock of implementation of the CAS, and makes some adjustments to the second half of the CAS program (FY07-FY08) to take account of developments since December 2004, in particular (i) the EU’s launch of negotiations with Croatia for EU membership in October 2005 and Croatia’s progress to date on the EU accession track, (ii) progress to date in meeting the CAS triggers and toward achieving the CAS outcomes, and (iii) the status of implementation of Croatia’s structural reform program supported by the Bank’s Programmatic Adjustment Loans starting in September 2005. This CAS Progress Report maintains the overall strategic framework of the CAS but with a more streamlined approach to CAS triggers and with some modifications to the lending program and the CAS Results Matrix, in light of evolving Government priorities and the need for greater selectivity and complementarity with Croatia’s EU accession agenda, now that EU accession negotiations are under way.

II.COUNTRY CONTEXT

A.Political Developments

  1. The coalition government formed by the center-right Croatian Democratic Union party (HDZ) in 2003 remains in office. It has reaffirmed Croatia’s European orientation and aims to make EU accession a reality. In addition, Croatia’s achievements under the Partnership for Peace process in the past couple of years are aiding the country’s quest for an invitation in 2008 for NATO membership.
  2. After the European Council granted Croatia candidate status in June 2004, the opening of accession negotiations was delayed from early 2005 until some pre-conditions were met. In October 2005 Croatia opened EU accession negotiations. The bilateral screening ended in October 2006, and negotiationsfor six of the 33 chapters of the accession treaty have been opened, while two (science and research, and education and culture) have already been provisionally closed. A further three (economic and monetary policy, enterprise and industrial policy, consumer and health protection and intellectual property law) have had closing benchmarks set. Assuming accession negotiations are finalized by early 2008, Croatia envisages accession in 2009.
  3. The next Parliamentary elections are scheduled for November 2007. While the ruling coalition’s majority currently still rests on only one seat, the likelihood of early elections remains small. The Government intends to sustain its fiscal discipline and structural reform momentum, but there are risks due to political pressures for fiscal relaxation during the pre-election period.

B.Economic Developments

  1. Benefiting from successful economic transformation after independence and the start of EU accession negotiations, economic activity has been robust in the past few years. Inflation has been modest despite increased oil and commodity prices, helped by central bank efforts to maintainexchange rate stability. Growth recovered in 2005 and continued strong in 2006. Real GDP growth, after moderating in 2004, accelerated to 4.3 percent in 2005 and further to 4.8 percent in 2006 (see Figure 1 and Table 1). Inflation has remained low at 3.2 percent in 2006, despite increased oil prices. Growth has been underpinned primarily by the growth in gross fixed investment (which grew 10.9 percent) and personal consumption (which grew 3.5 percent.) Government consumption has increased as well, by 2.2 percent. Financial intermediation, industry, transport and communicationshave been the key contributors to GDP growth. Total industrial production recorded a 5.1 percent growth rate in 2005 but has decelerated in 2006 to 4.5 percent.


Table 1: Selected Medium-Term Macroeconomic Indicators

2005 / 2006
Preliminary / 2007
Projected4/ / 2008
Projected4/
Read GDP Growth (%) / 4.3 / 4.8 / 4.6 / 4.0
GNP per capita (US$, Atlas method) / 8,000 / 8,880 / 9,510 / 10,060
Investment (% of GDP): / 31.0 / 32.8 / 33.1 / 33.4
Public (% of GDP) / 5.2 / 5.3 / 5.0 / 4.6
Private (% of GDP) / 25.8 / 27.5 / 28.1 / 28.8
CPI Inflation (% annual) / 3.3 / 3.2 / 2.7 / 2.5
Real Interest Rate1/(%) / 6.5 / 6.0 / 7.1 / 6.8
Current Account Balance (% of GDP) / -6.6 / -7.4 / -7.0 / -5.8
Annual value growth rates (%):
Merchandise Exports (f.o.b.) / 9.1 / 18.4 / 7.0 / 7.0
Merchandise Imports (f.o.b.) / 10.5 / 15.4 / 6.3 / 5.0
Capital and Financial Account (% of GDP) / 9.3 / 11.4 / 8.6 / 7.7
FDI, net inflow (% of GDP) / 4.0 / 7.8 / 6.0 / 3.3
Overall Fiscal Balance2/ (% of GDP) / -3.9 / -3.1 / -3.0 / -2.8
Public Debt3/ (% of GDP) / 52.3 / 49.6 / 49.4 / 48.6

1/ Real lending short-term rate

2/ General Government Balance (includes all LGUs)

3/ Includes General Government, HBOR and guarantees

4/ Base case scenario

  1. Moderate fiscal consolidation has taken place. Fiscal policy has tightened in the past few years to arrest growth in public debt, but less than initially planned: the fiscal deficit declined from 4.8 percent of GDP in 2004 to 3.9 percent in 2005, and a preliminary 3.1 percent in 2006.[1] While noteworthy, once the quasi-fiscal activities are added, this is still above a sustainable level by about one percentage point of GDP. The public debt-to-GDP ratio rose slightly from 51.6 percent in 2004 to 52.3 percent in 2005, but then declined to 49.6 percentby December 2006 with the help of a slowdown in guarantees’ issuance and financing of pensioners’ debt repayment through privatization receipts. Further fiscal consolidation is needed, as indicated by the fact that the size of the state remains high by international standards[2]at 48.8 percent of GDP in 2005.
  2. Further fiscal consolidation is also required because the scope for increasing tax revenues is limited. Relying on privatization receipts to finance deficits is not a viable medium-term strategy, since they are expected to decline after Telecom and HEP Electrical Company IPOs. The overall tax burden in Croatia is high even in the European context, given the level of Croatia’s economic development. Croatia taxes directly and indirectly 39 percent of its GDP.[3] However, without cuts in public spending, tax reduction is not feasible.
  3. After a cooling down, domestic credit expansion has picked up again since 2004, driven by the shift in government borrowing towards the domestic market and rising corporate sector activity. Domestic credit growth at 20.3 percent in 2005 was eight percentage points higher than monetary authorities’ target. Loans to government and households rose by 44.1 percent and 20.3 percent, respectively. The Croatian National Bank has taken several measures to discourage foreign borrowing by banks, including the increase of the marginal reserve requirement on new bank borrowing from abroad, first from 30 to 40 and then to 50 and 55 percent.
  4. These domestic policy measures have not been sufficient to curtail the credit expansion and subsequent rise in the current account deficit. Credit growth increased to 22.7 percent in 2006. Loans to households and enterprises rose by 21.8 percent and 26.1 percent, respectively. The current account deficit (in USD terms) increased to 6.6 percent of GDP in 2005 from 5.2 percent in 2004, and grew further to 7.4 percent of GDP in 2006, despite strong growth in exports of goods (non-ship) and services. The trade deficit widened by 11.9 percent compared to 2004 and further to 15.8 percent in 2006. Net FDI inflows stood at 4.0 percent of GDP in 2005, nearly double the 2004 level, and grew to 7.8 percent of GDP in 2006, in excess of current account deficit financing needs. Net FDI inflows are projected to continue strong in 2007 and 2008, given the upcoming Telecom and HEP Electrical Company IPOs.
  5. As a result, external debt has continued to rise and with it, the country’s external vulnerability. Gross external debt (in EUR) stood at 84.7 percent of GDP in December 2006, up 5.3 percentage points of GDP since end-2004, owing to strong capital inflows to domestic banks and rising corporate sector borrowing from abroad. In USD terms, the external debt-to-GDP ratio declined by about nine percentage points of GDP to 77.7 percent in 2005 but rose to 89.0 percent of GDP by December 2006, partially driven by USD depreciation. In 2005, in order to reduce foreign indebtedness, the Government shifted from foreign to domestic sources of finance, but since domestic banks are re-lending loans from foreign mother banks, the public sector continued to contribute indirectly to the external debt growth. The monetary policy further tightened at end-2006 with an introduction of compulsory purchase of Croatia National Bank (CNB) bills on credit growth in excess of 12 percent per annum. However, discretionary measures tend to have limited impact on the supply side pressures and unless accompanied by tighter demand-side controls, through stronger fiscal consolidation efforts, external vulnerability will continue to grow in 2007.
  6. Continued external vulnerability poses a risk to macroeconomic stability and leaves the Government with little room to maneuver in the event of shocks. Given the high degree of euroization of the Croatian economy, external shocks could potentially cause substantial damage. Hence, arresting the growth of external debt is critical to reducing Croatia’s macroeconomic vulnerability over the medium term.
  7. The Stand-By Arrangement (SBA) of the IMF for Croatia was extended from April to November 15, 2006. The first and second reviews experienced delays, and the third review was concluded on September 29, 2006. The objective of SBA was to reduce external vulnerabilities by narrowing the domestic saving-investment gap and stabilizing the external debt-to-GDP ratio. With the exception of the one dealing with general government arrears, all end-September quantitative performance criteriafor the third review were met. But as indicated above, the ultimate goals of the program have remained somewhat elusive.

C.Governance

  1. Progress in strengthening public financial management has been mixed, with good progress in a number of important areas such as a single treasury account and internal audit but with continuing weaknesses in control over expenditures, guarantees, and arrears, and a delay in adoption of a new Public Procurement Law aligned with EU requirements. Greater attention to some of these budget execution issues could contribute towards addressing fiscal challenges. Improvements in public financial management arealso having a positive impact on the overall level of fiduciary risk. Country systems are already being relied upon to a considerable extent, and further progress is expected as Croatia moves closer to harmonization with EU standards. Public procurement capacity has been strengthened with support from the EU, and adoption of the new Public Procurement Law is expected in 2008.
  2. The results of the EBRD-World Bank Business Environment and Enterprise Performance Survey (BEEPS) indicate that corruption has declined in Croatia since 1999. The Parliament approved a new Anti-Corruption Program 2006-2008 in 2006, with special attention devoted to areas where corruption is considered to be most prevalent, such as the judiciary, health services, local government, and public administration. An ambitious action plan which covers all the ministries was subsequently prepared. The capacity of the Office for the Prevention of Corruption and Organized Crime has been strengthened and has signed a cooperation agreement with the Ministry of Finance and the Tax Administration. Reforms launched include the adoption of ethics codes, codes of conduct in the public sector, conflict of interest legislation, and public procurement and state aid legislation; depoliticization of public administration; reform of political party financing; and direct election of city mayors and county prefects. Effective prosecution of malfeasance will require strong political commitment, which will be tested as implementation proceeds. However, monitoring by the EC can be expected to help Croatia stay on course.

D.Social Developments

  1. The poverty analysis conducted in 2006[4]as input to the Croatia Living Standards Assessment (LSA)[5]indicates that poverty in Croatia is relatively low and shallow but has not changed since the last poverty assessment in the late 1990s. Four percent of the population live on less than US$ 4.30 a day (at the purchasing power parity), and about 11 percent live on about US$ 10 a day, which the LSA suggests is an absolute poverty line for Croatia. Another ten percent of population is at risk of poverty, as their average consumption is less than 25 percent above the poverty line. About one percent of the population faces severe deprivation.