2012 International Monetary Fund November 12, 2012

IMF Country Report No. 12/303

July 29, 2012 January 29, 2001 January 29, 2001

January 29, 2001 January 29, 2001
Republic of Croatia: Selected Issues

This paper on Selected Issues was prepared by a staff team of the International Monetary Fund as
background documentation for the periodic consultation with the member country. It is based on the
information available at the time it was completed on October 23, 2012. The views expressed in this
document are those of the staff team and do not necessarily reflect the views of the government of the
Republic of Croatia or the Executive Board of the IMF.

The policy of publication of staff reports and other documents by the IMF allows for the deletion of
market-sensitive information.

Copies of this report are available to the public from

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International Monetary Fund

Washington, D.C.
 INTERNATIONAL MONETARY FUND

REPUBLIC OF CROATIA

Selected Issues

Prepared by Reginald Darius and Graldine Mahieu

Approved by European Department

October 23, 2012

Contents Page

I. What Has Kept Croatias Growth Low and How to Boost It? .............................................. 3
A. Croatias Growth Performance ........................................................................................ 3
B. The Spence Commission Growth Report ........................................................................ 6
C. The Growth Diagnostics Approach ............................................................................ 11
D. The Standard Reform Package or Washington Consensus ........................................ 16
E. Reform Priorities in Croatia ........................................................................................... 17
F. Possible Impact of the Reforms ...................................................................................... 20
G. Conclusions .................................................................................................................... 22

References ............................................................................................................................... 23

Table
1. Doing Business Indicators .................................................................................................. 19

Appendix Figures
1. Relative Growth Performance, 200011............................................................................. 24
2A. Middle-Income Countries: Growth Accounting, 200008 .............................................. 25
2B. Middle-Income Countries: Growth Accounting, 200911 .............................................. 26
3. Middle-Income Countries: Employment Growth Decomposition, 200011 ...................... 27
4. Education Level of the Labor Force ................................................................................... 28
5. Openness to the Global Economy ....................................................................................... 29
6A. Business Environment, 201112...................................................................................... 30
6B. Business Environment, Components, 200512................................................................ 31
7. Access to International Financing, 200008 ....................................................................... 32
8. Access to Domestic Financing ............................................................................................ 33
9. Croatia and other Eastern European Countries: Structure of Production by Branches ...... 34
10. Investment Structure ......................................................................................................... 35
11. EU and US: Average TFP Growth by Sectors, 199507, annualized .............................. 36
 2

12. Croatia: Cost of Finance, 200811 ................................................................................... 37

13. Croatia: Innovation Performance ...................................................................................... 37

II. CroatiaExport Performance, Wages, and Productivity .................................................. 38

A. Introduction .................................................................................................................... 38
B. Key Findings .................................................................................................................. 38
C. Current Account Balance and External Vulnerabilities ................................................. 39
D. Export Performance and Market Share Analysis ........................................................... 40
E. Wages and Export Performance: A Micro Analysis ...................................................... 43
F. Conclusion ...................................................................................................................... 48

Tables
1. Export Growth Productivity and Wage Gap (P-W) ............................................................ 45
2. Export, ULC, and Productivity Growth (correlation), 200008 ......................................... 46
3. Market Share (Exports of Eastern Europe to the European Union).................................... 47

Appendix Figures
1. Market Share, 200011 ....................................................................................................... 49
2. Eastern Europe: Export and ULC, 200008 ....................................................................... 50
3. Eastern Europe: Export and ULC, 200008 ....................................................................... 51
4. Eastern Europe: Export and ULC, 200008 ....................................................................... 52
5. Eastern Europe: Export and ULC, 200008 ....................................................................... 53
6. Eastern Europe: Export and ULC, 200008 ....................................................................... 54
 3

I. WHAT HAS KEPT CROATIAS GROWTH LOW AND HOW TO BOOST IT?1

In the past decade, Croatias GDP growth has lagged behind growth in most emerging
markets including its European peers. Croatias sub-performance is most notable since the
crisis from which it has not yet recovered. The paper investigates the main reasons behind
this weak performance and proposes specific policy recommendations to boost growth
potential, drawing on three strands of economic thought: (i) the Spence Commissions
Growth Report; (ii) the Growth Diagnostics approach of HaussmannRodrikVelasco;
and (iii) the Washington Consensus. The policy prescriptions coming from these three
approaches are very similar: (i) increase work incentives to boost labor force participation
and improve labor market flexibility, which will help regain competitiveness; (ii) improve
business environment and foster competition to help attract capital, particularly FDI, into
the tradable sectors; and (iii) continue the fiscal consolidation efforts to reduce
macroeconomic risks and thus improve the cost and availability of capital. Estimates suggest
that the impact of these reforms on growth could be quite substantial, potentially raising
growth by about 2 percent in the medium to long term.

A. Croatias Growth Performance

1. Croatias GDP growth per capita in 20002011 averaged 2 percent. This is

below the growth performance in most middle-income countries and in most of Croatias
Eastern European peers.2 Countries such as Argentina, Peru, Thailand, Slovak Republic,
Bulgaria, or the Baltics have achieved substantially higher rate of growth over this period.

12
Middle-Income Countries: Change in Real GDP Per
10
Capita, 2000-11, Annualized (percent)
8
6
4
2
0
-2
-4 200008 200911 200011
-6
-8
Czech Republic
Costa Rica

Macedonia

Montenegro

Dominican Republic

Russia
Colombia

Romania
Estonia

Moldova
Latvia
Venezuela
Malta

Lithuania
Argentina
Slovenia
South Africa

Thailand
Turkey

Slovak Republic
Mexico

Brazil

Chile
Hungary

Croatia

Uruguay

Bulgaria

Ukraine
Peru
Portugal

Greece

Panama
El Salvador

Ecuador
Cyprus

Bosnia

China
Poland

Albania
Serbia

Source: WEO

1
Prepared by Graldine Mahieu.
2
The peer group of middle-income countries is defined as countries from Europe, Latin America, Asia, and
Africa with a mid-level GDP per capita in PPP terms (between the one of Ukraine and Slovenia), plus Moldova.
Very small countries and islands are excluded to contain the sample size.
 4

2. Even accounting for convergence, Croatias growth performance remains

modest. Its GDP growth rate in the past 2.5
Growth beyond what is explained by convergence,
decade has been lower than what could 2 2000-2011, annualized (percent)
be expected, even taking into account its 1.5
relatively high GDP per capita, while 1
others have done much better by the 0.5
same metric (text chart).
0

3. Croatias sub-performance is -0.5

particularly notable for the last three -1

years. Real GDP growth per capita -1.5

averaged 4.1 percent over 20002008. -2

Czech Republic

Slovak Republic
Croatia

Ukraine
Bosnia

Russia
Macedonia

Moldova

Romania
Serbia

Albania

Poland
Estonia
Latvia
Slovenia

Lithuania
Turkey
Hungary

Bulgaria
While this looks relatively sound, this
performance is significantly weaker than
some of its emerging Europe peers with
similar (Estonia, Slovak Republic) and Sources: WEO and IMF staff calculations. The adjusted growth measures the
difference between each country's actual growth rate and the one that would
even higher (Czech Republic or be expected given its initial income level, based on a growth regression
for European countries.
Slovenia) initial GDP per capita
(Appendix Figure 1). The growth differential is even larger in the crisis and post-crisis period
where Croatia underperformed most of its middle-income and CEEC peers.3 Not only was
Croatia hit strongly by the global crisis in 2009 (registering an annual real GDP growth rate
of -6.9 percent), but it has not yet recovered from it (with an average annual growth rate of
-0.7 percent in the last two years).

4. Estimates suggest that Croatias GDP growth has been primarily driven by
capital accumulation. The contribution from total factor productivity was more limited
while labor contribution was low. Estimates using a Croatia specific production function4
(text table) or based on a cross-countries growth accounting exercise5 (Appendix Figure 2a
and 2b) show the same results. As expected during the crisis years, the contribution from
capital was reduced due to lower investment while labor and TFP contribution fell strongly
and more than in most peers. The relatively low TFP growth in Croatia is puzzling given the
high capital accumulation, which is usually conducive to high TFP growth.

3
Croatias GDP per capita growth rate averaged -2 percent over 20092011 compared to 0.7 percent in middle-
income countries.
4
These estimates use a Cobb-Douglas production function with employment share calculated as the total wage
bill over GDP ratio (leading to an employment share ranging between 0.40.5 depending on the years).
5
Following G. Mourre (2009), the growth accounting exercise assumes a constant share of labor of 65 percent
while the net capital stock is constructed via the perpetual inventory method (with the capital stock over GDP
assumed to be 2 in 1995).
 5

GDP growth and contributions

2000-2008 2009-2011 2000-2011
Real GDP Growth 4.3 -2.8 2.5
Contributions:
- capital 2.6 1.5 2.3
- labor 0.5 -1.4 0.0
- productivity 1.2 -2.9 0.2

5. Unfavorable demographics and low activity rate explain the low contribution of
labor to growth before the crisis. Employment growth in Croatia has been lower than in
most middle-income and emerging Europe countries (Appendix Figure 3). This is partly due
to a very low growth of working-age population as the economy is ageing.6 In addition,
starting from a relatively low level, the participation rate has further declined over time,
while it has increased in other peers such as Estonia or Bulgaria. On the other hand,
employment rate has been increasing more in line with peers, although some countries (such
as Slovakia, Lithuania, or Bulgaria) have done better. This suggests that the problem in the
pre-crisis period may have been predominantly connected with labor supply issues. During
the crisis, the fall in employment (about -2.5 percent per year) was one of the most dramatic
registered in middle-income countries. This was largely the result of the sharp fall in demand
for labor, although falling population and participation rate further worsened the picture.7

6. The growth accounting exercise suggests that Croatias far-from-perfect pre-

crisis growth model has run its course. The capital accumulation driven pre-crisis growth
model did not generate significant productivity gains and its record of employment creation
was limited due to labor supply constraints, questioning its sustainability given the growing
external debt. Growth significantly fell in 2009 and has not yet turned positive since then. As
capital risks being less forthcoming and more expensive in the future than in the pre-crisis
period, a fundamental change in Croatias growth model is needed to return to a reasonable
medium-term GDP growth and reverse the sharp increase in unemployment.

7. In order to gain more insight into the reasons behind Croatias moderate growth
performance and provide policy recommendations to boost medium-term growth, the rest of
the paper will look into three strands of economic thought: (i) the Spence Commissions

6
The employment growth can be expressed as the combination of four factors: (i) population growth; (ii)
growth of the working-age population; (ii) growth of the participation rate; and (iv) growth of the employment
rate. Formally, total employment = population * (pop 1564/population)* (labor force/pop 1564) *
(employment/labor force), with the three ratios being respectively the share of working population, the
participation rate and the employment rate.
7
The decomposition using working age population for the crisis period is not possible due to missing data.
 6

Growth Report; (ii) the Growth Diagnostics approach of HaussmannRodrikVelasco; and

(iii) the Washington Consensus.

B. The Spence Commission Growth Report 8

Content

8. The report brought together the views of a Commission of 19 leaders, mostly

from emerging markets and developing countries, and two academics (Robert Solow and
Michael Spence). Their aim was to identify the characteristics of successful growth stories,
using 13 high-growth economies (which have grown at an average rate of at least 7 percent a
year for at least 25 years) as examples, and explore how other countries could emulate them.
The report identified several policy ingredients for growth that could be regrouped into five
different categories.

Full exploitation of the global economy

9. High-growth countries fully exploited the opportunities provided by the global

economy and were notably characterized by:

Strong reliance on exports to increase economies of scale and specialization;

High level of FDI and imported technology, using measures to attract FDI (such as
promotion campaigns) and measures to extract more knowledge from foreign
investment (via joint venture for instance).

High rate of investment

10. If the high-growth cases are any guide, investment rates above 25 percent
(counting both public and private investment) seem needed to grow fast. Strong
investment in infrastructure (57 percent of GDP), notably in ports, roads, airports,
telecommunications and power as well as high investment in human capital (with the
combined public and private investment in education, health and training amounting to about
78 percent of GDP) appear particularly important.

Macroeconomic stability

11. During their most successful growth periods, the 13 high-growth cases avoided
large macroeconomic volatility. Factors that seem particularly crucial are:

8
The full name is The Growth ReportStrategies for Sustained Growth and Inclusive Development by the
Commission on Growth and Development, 2008, IBRD.
 7

Stable and single digit (but higher than 2 percent) inflation;

Light exchange rate management, which should at best serve two purposes:
(i) slightly favor exports in the early stages of development; (ii) prevent a surge of
capital inflows;

High domestic savings to finance investment;

Removal of capital controls only when the structural transformation of the economy
is well advanced and the financial sector is matured enough.

Market allocation of resources and strong resource mobility

12. Governments in high-growth economies did not resist to the process of

structural change and creative destruction in their economies. High growth economies
were characterized by strong competition and notably easy entry and exit of firms on the
market. High mobility of resources (notably of labor) was also a feature of all 13 high-growth
cases.

Quality governance

13. High-growth economies were leaded by committed, effective, and capable

governments, which: (i) understood that successful development entails a decades-long
commitment; (ii) recruited the right persons and gave them the right incentives (salary linked
to performance); (iii) were pragmatic in their approach, tried, failed and learned from their
mistakes and were ready to change policies when the situation evolved; (iv) exposed their
ideas to quality debates (for instance, reform teams composed of a small number of highly
qualified and dedicated technocrats were created in Korea, Japan, Malaysia, and Taiwan).

Application to Croatia and policy lessons

14. With respect to these key growth ingredients, Croatia performed relatively well
regarding the investment rate and macroeconomic stability. Investment rates in Croatia
averaged 24 percent of GDP in 200008, only slightly below the 25 percent minimum level
advocated in the Spence Report and comparing favorably with the countrys middle-income
or emerging Europe peers, even those with high GDP growth rate (text chart). The
investment ratio however declined post-crisis, from 28 percent in 2008 to 22 percent in 2011.
Investment in infrastructure was also elevated in Croatia (Appendix Figure 10), while the
education level of the labor force appears broadly adequate (at least at the secondary
education level, while the share of labor force with tertiary education is lower, Appendix
Figure 4). Macroeconomic stability has also been largely ensured with an average inflation
rate of 2.9 percent in 200011, a broadly stable nominal exchange rate providing an anchor
for inflation expectations and financial stability, and high level of domestic savings.
 8

45
Middle-Income Countries: Investment over GDP, 2000-2011
40 (percent)
35
2000-2008 2009-2011 2000-2011
30

25

20

15

10

Czech Republic
Costa Rica
South Africa

Mexico

Slovak Republic
Ukraine

Croatia
Malaysia
Dominica

Portugal
Panama
Cyprus

Ecuador

Bosnia
Russia
Greece

Montenegro
El Salvador

Dominican Republic

Colombia

China
Moldova

Romania
Serbia

Estonia
Poland

Albania
Malta
Argentina

Venezuela

Latvia
Thailand
Slovenia
Lithuania
Turkey
Brazil

Chile

Bulgaria
Uruguay

Hungary
Peru
Sources: WEO and IMF staff computations

55
50 Middle-Income countries: saving to GDP ratio, 2000-2011
2000-2008 (percent)
45
2009-2011
40
2000-2011
35
30
25
20
15
10
5
Czech Republic
Costa Rica
South Africa

Slovak Republic

Mexico
Ukraine
Croatia
Panama

Malaysia
Portugal

Ecuador
Montenegro
Greece

Bosnia

Russia
El Salvador
Cyprus

Dominican Republic

China
Macedonia
Romania

Colombia
Moldova
Albania

Estonia
Serbia

Poland

Latvia

Venezuela
Malta

Lithuania

Argentina

Slovenia
Thailand
Turkey

Chile
Brazil
Uruguay

Hungary
Bulgaria

Peru

Source: WEO

15. However, with respect to the other key growth-generating factors, Croatias
performance has been much less outstanding. While FDI inflows to Croatia (averaging
about 5 percent of GDP over 200011) have been in line with other middle-income countries,
they have been lower than in many other European partners (Appendix Figure 5). In addition,
they have largely been directed to non-tradable sectors rather than to manufacturing, limiting
their contribution to improving productivity and competitiveness. FDI inflows however
sharply fell in 201011, notably in non-tradables, reflecting the crisis in the financial sector
and the construction bust.
 9

10 10
Structure of FDI Inflows (Percent of GDP)

8 8
Tradeables Nontradeables

6 6

4 4

2 2

0 0

-2 -2

Source: WEO and IMF staff computations

16. Croatia is also a relatively closed economy, with its share of export of goods and
services amounting to about 40 percent of GDP, well below the 5055 percent reached on
average in other CEECs or the fast growing middle-income countries (above 70 percent).
Croatias trade openness has also remained strikingly constant over time while its rapidly
growing peers enjoyed increasing trade integration which helped them support their GDP
growth (Appendix Figure 5).

17. Labor market flexibility is limited due to strong employment protection and
strict regulations, particularly in the public sector. Hiring and firing costs are high,
notably due to high tax wedge on labor, relatively high severance payments, numerous
administrative loops for collective dismissals and pro-labor bias of courts, all of which
considerably raise dismissal costs. There is also little flexibility to adjust working hours.
Collective agreements (with a coverage of 5060 percent), especially in the public sector,
contribute to wage rigidities as, until recently, they could not be changed without explicit
trade union agreement and all provisions of a collective agreement of definite duration
continued to be valid after it expires until a new agreement has been signed (the so-called
after-effect). Indicators of structural competitiveness (such as the global competitiveness
index or economic freedom index) also point to the lack of flexibility of the labor market as a
key obstacle to investment in Croatia. Rigid labor market regulations as well as generous
social benefits (notably the low penalty for early retirement, low statutory age of retirement,
generous sick leave benefits) have led to a very low labor force participation, among the
lowest in middle-income countries, as well as very high unemployment (13 percent in 2011).
 10

100
Middle-Income Countries: labor force participation rate,
2009 (percent)
90

80

70

60

50

40

Czech Republic
Malaysia

Costa Rica

Russia
Dominican Republic

Colombia
macedonia
Romania

Estonia
malta

Venezuela

Thailand
Argentina

Lithuania
Slovenia
South Africa

Mexico
Turkey

Slovak Republic

Brazil
Chile
Uruguay

Hungary
Croatia

Bulgaria

Ukraine

Peru
latvia

Portugal
Panama
Ecuador
Bosnia

greece

China
El Salvador

cyprus
Albania
Serbia

Poland
Sources: WEO, WBWDI and IMF staff calculations

18. Croatia also ranks poorly in terms of competition and product market efficiency,
as reflected in the indicators of business environment (Appendix Figures 6a and 6b).
These indicators all points to the same deficiencies, namely the high taxation, the high
regulatory obstacles for starting or conducting a business (and particularly the slow
procedures for obtaining a construction permit and registering a property and barriers to
investment at the local government level), the inefficient legal framework (poor competition
policy, low investor protection, slow resolution of insolvency), the inefficient and wasteful
government spending and the slow process of privatization and enterprise restructuring. On
the positive side, Croatia ranks well on infrastructure and education, and moderately well on
macroeconomic environment (except on budget balance).

19. Finally, several governments have been slow in addressing the long-standing
competitiveness problems. The government launched a comprehensive and well-targeted
reform package called the Economic Recovery Program (ERP) in April 2010. However,
implementation has been slow and patchy due to strong resistance from vested interests.
Progress has been made in some areas (notably reduction in health expenditures and
unemployment benefits, pension reform), but very limited reforms have been launched to
foster labor market flexibility, improve business climate, and reduce the size of the public
sector. The general government wage bill is higher than in most new EU member states,
mainly as a result of high public sector employment. In addition, a highly compressed pay
structure and poor link between salary and performance work as a disincentive to attract and
retain quality workers in the public sector.

20. If these 13 high-growth cases are any guide, the key policy recommendations for
Croatia would be:

increase labor market flexibility;

 11

improve business environment;

improve government efficiency, through administration rationalization and reform of
the pay structure.
These reforms are likely to facilitate economic restructuring, foster competition, and help
attract more capital in the tradable sector, thereby increasing Croatias competitiveness and
openness.

C. The Growth Diagnostics Approach

The methodology

21. Haussmann, Rodrik, and Velasco (2005) develop a framework for growth
diagnostics that identifies the binding constraints on growth in a country. The goal is to
help set up the policy priorities which will provide the biggest bang for the reform buck and
hence use the scarce political capital of reformers most efficiently. The framework is based
on two equations:

One for capital accumulation per capita, which is a function of the difference between
the rate of return on capital net of tax and the world interest rate;

Another one expresses the rate of return on capital as a function of total factor
productivity (TFP), complementary factors of production, and externalities.

22. The exercise of growth diagnostics simply consists of reviewing and analyzing
these factors to ascertain by a process of elimination which are the most binding
constraints on growth. The main idea of the analysis is that if one factor is scarce and a
binding constraint for growth, its price should be elevated and economic growth higher when
the constraint is relaxed. The decision tree below helps to identify the most binding
constraint on growth. The starting point is to determine whether the problem of low
investment is due to too high cost of financing or low private return on domestic investment.
Depending on the answer to this question, the analysis moves along the decision tree to
identify where the most problematic issue is.
 12

Application to Croatia

The pre-crisis period

23. Applying the growth diagnostic to Croatia suggests that during the pre-crisis
period (200008), capital accumulation does not seem to have been the binding
constraint to growth. Several elements support this conclusion:

Low rate of investment? As seen in the previous section, Croatias investment to GDP
ratio at 24 percent in 20002008 does not seem low compared to its peers
(Appendix Figure 7).

Bad international finance? The large capital inflows to Croatia in the last decade
suggest that Croatia was able to attract foreign savings. Also interest on bonds as
shown by the CDS spreads were relatively moderate compared to Croatias peers and
declining during the period (Appendix Figure 7).

Bad local finance? Domestic savings were ample, while relatively low and decreasing
interest rates on loans and deposits do not suggest scarce capital. Real lending rates
for corporates were relatively close to real GDP growth in 20002008, also not
indicating any major issues with the cost of capital (Appendix Figure 8).

24. This exercise seems therefore to suggest that prior to the crisis the major
constraint on Croatias growth has not been the low level of investment but the poor
 13

allocation of this investment. This is probably due to an inefficient allocation of capital into
low valued-added sectors and overall low production efficiency:

As shown above, Croatias total factor productivity improvement over 20002008 has
indeed been lower than in most of its Eastern European partners.

The structure of production was also largely titled towards non-tradable sectors, with
a particularly low share of industry (Appendix Figure 9).

Also, capital flows, including FDI, were mostly directed towards consumption-related
and inward-oriented sectors rather than towards productivity enhancing investment.
Investment in industry averaged only 20 percent, significantly less than in other
CEECs. On the other hand, Croatia invested significantly more than its peers in
financial, construction and tourism sectors (Appendix Figure 10).

Evidence for the EU and the US shows that these non-tradable sectors were in general
a weaker source of productivity growth (Appendix Figure 11). The inefficient
allocation of capital in Croatia could hence explain the low TFP and GDP growth in
the pre-crisis period despite the relatively strong investment ratio.

Croatia - Structure of Investment, average 2004-

2009
agriculture

public
services
other industry
business
services

f inancial trade
intermediati
on
transport
construction f ood and and storage
accomodati
Source: Croatia National statistics on

Crisis years (20092011) and future growth

25. While the level of investment does not seem to have been a constraint in the pre-
crisis period, it could have become one since the crisis. As noted above, investment has
fallen sharply since 2009 with total and private gross fixed capital formation decreasing by
more than 10 percent annually over the last three years, leading to a much lower contribution
of capital accumulation to growth. FDI inflows have more than halved since 2009. As above,
a process of elimination based on the decision tree could help identify the key constraint for
growth.
 14

High cost of finance? International finance has become scarcer since 2009 with lower
capital inflows, higher global risk aversion and higher CDS spreads for Croatia (text
chart and Appendix Figure 12). There is a risk that capital flows may be less
forthcoming in the future given Croatias elevated external debt to GDP ratio and low
growth prospects, possible further deleveraging by euro area banks, and better
country differentiation by markets, although EU accession could help boost capital
inflows in the medium-term. In addition, while domestic savings has remained
relatively high and deposit rates moderate, credit growth has fallen significantly since
early 2009. Real lending rates are also above their pre-crisis level, reflecting higher
banks funding costs and the need for banks to keep lending-deposit spreads elevated
to compensate for growing provisions for NPLs.

Low social returns? Social returns remain high with Croatias central location in
Europe, ready access to the sea and long coastline underpinning its tourism industry.
As said above, public expenditure on infrastructure and education has been high and
does not seem to be a major constraint for growth.

Low appropriability owing to elevated risks? Market failures do not appear to have
been a major issue in Croatia given reasonable levels of innovation (with R&D
expenditure and patents granted broadly in line with its peers, Appendix Figure 13).
However, large fiscal deficits have significantly increased public debt level, with debt
dynamics being now unsustainable in the absence of strong fiscal consolidation.
External vulnerabilities have also increased over last years with external debt
reaching 100 percent of GDP, external financing requirement of about a third of
GDP, and a high degree of euroization. In addition, the poor business environment (as
detailed above) and well as the high wage and taxation level have likely impeded
growth. Using Haussmann, Rodrik and Velascos terminology, higher macro and
micro risks have reduced the return of investing in Croatia, thereby contributing to the
decline in capital inflows and investment.
 15

Capital Inflows
(Percent of 2000 GDP; average of 200911)

100 FDI Portfolios Others Total

50

-50

-100

Macedonia, FYR

Czech Republic

Bosnia & Herzegovina

Russia

Romania

Moldova
Montenegro, Rep. of
Switzerland

Estonia

Austria

France
United Kingdom
Latvia

Malta
Lithuania

Sweden

Slovenia

Slovak Republic
Turkey
Bulgaria
Hungary

Iceland

Ukraine

Croatia
Netherlands

Spain
Denmark

Portugal
Belgium

Finland

Greece
Norway

Cyprus
Ireland
Germany

Italy

Albania
Poland
Sources: World Economic Outlook database; and IMF staff calculations.
In percent of 2003 GDP; average of 200311.

Policy recommendations for Croatia based on the growth diagnostic

26. The analysis shows that Croatias binding constraints for growth have evolved
over time. Before the crisis the level of investment was not a constraint for Croatias growth,
as it was able to attract high foreign capital flows. Rather, the poor allocation of capital
towards non-tradable and low productivity sectors is likely to have been a drag on growth
performance. Since the crisis, the deficiencies of Croatias economic model and policies,
combined with limited and more costly financing have given rise to elevated risks that lower
perceived returns on investment in Croatia and have thus emerged as key constraints for
growth.

27. While there is not much to be done to influence global risk aversion, a credible
and sustainable fiscal consolidation would help. It would reduce Croatias vulnerabilities
and therefore lower the cost and improve availability of financing. Also, lower public deficit
would reduce the risk of crowding out private investment and allow a reduction of the tax
burden on labor, thereby improving Croatias attractiveness to foreign investors.

28. In addition, several other policies could be implemented to raise the returns on
investing in Croatias tradable sector and help rebalance the economy. These include
measures to:
 16

Improve business environment and Croatias attractiveness by easing regulatory

obstacles to business, improving the judicial system, and increasing the efficiency of
the public administration.

Improve competition and productivity via faster restructuring and privatization of

loss-making state-owned enterprises and reduction of subsidies to agriculture and
other loss-making sectors.

Increase labor market flexibility by easing labor markets regulations and reducing
insider protection. More flexibility in setting wage contracts and lower hiring and
firing costs will induce more competitive wage setting and raise the profitability of
investment in tradable sectors.

D. The Standard Reform Package or Washington Consensus

29. The policy recommendations outlined above could be compared with the set of
policy prescriptions aimed at promoting growth that form the core of IMFs and World
Banks usual policy advice. This reform package is often referred to as the Washington
Consensus, as termed by the economist John Williamson in 1989. While the Washington
Consensus has evolved over time, in a learning-by-doing mode, it essentially relies on three
main ideas: liberalization, privatization, and deregulation.

30. Croatia performs well on liberalization. Croatia is already a market economy, open
to trade and therefore ranks high in the EBRD transition indicator for price, trade, foreign
exchange, bank and interest rate liberalization.

31. Croatia is however lagging in terms of large-scale privatization, enterprise

restructuring, infrastructure reforms and competition policy (text chart). While some
progress has been recorded on competition policy (due to improvement in law enforcement
and further strengthening of the competition law), no progress was made since 2008 in the
other three items, highlighting the stalling of the structural reform momentum. Privatization
has only seen very slow progress in recent years with the portfolio of state-owned companies
still comprising about 645 companies, most of them highly indebted and loss-making, and no
clear strategy to deal with them. The lack of progress is also particularly notable for the
railway sector, which cannot survive without substantial state subsidies and is uncompetitive
compared to other European companies owing to low traffic intensity, low staff productivity,
high operating costs, and outdated infrastructure. Despite liberalization since 2008, Croatias
electricity and gas markets are still dominated by monopolistic suppliers.
 17

Croatia: EBRD transition indicators, 2000-2010

Price liberalization 2000
2008
Trade and Foreign Exchange System
2010
Banking reform & interest rate liberalization Average 2010 others

Small scale privatization Max 2010 others

Large scale privatization

Enterprise restructuring

Competition Policy

Securities markets & non-bank financial institutions

Overall infrastructure reform

Telecommunications

Railways

Electric power

Roads

Water and waste water

Source: EBRD 2 3 4 5 6

32. As a result, the standard policy recommendations for Croatia would focus on
policies aimed at:

Accelerating privatization and restructuring of state-owned companies;

Increasing labor market flexibility and easing labor tax burden;
Easing regulatory obstacles to business and strengthening competition.

E. Reform Priorities in Croatia

33. Interestingly, the policy prescriptions from the three approaches reviewed are
very similar. They evolve around three themes: (i) increase work incentives to boost labor
force participation and improve labor market flexibility; (ii) improve business environment
and foster competition; and (iii) consolidate government finances to reduce macroeconomic
risks that deter investment. These reform priorities are in line with the structural indicators of
competitiveness, which point to these issues as the most problematic obstacles for doing
business and investing in Croatia.
 18

34. Reforming Croatias labor market should aim at increasing both supply and
demand of labor.

Reforms should aim at enhancing work incentives. While the government has taken
some measures to increase labor force participation (via reduced possibilities and
incentives for early retirement, gradual increase in retirement age for women, reform
of the unemployment benefits, and better control of sick leave), they are unlikely to
be sufficient. Notably, half of the planned increase in women retirement age will be
compensated by the regular ageing process. A faster increase in the retirement age for
women (for instance by 6 months per year rather than the 3 months per year decided
in 2010) to 65 and a further increase to 67 for all would help offset the impact of
ageing and boost labor supply (in addition to reducing the deficit of the pension
system). In addition, early retirement incentives remain too high. The penalty for
early retirement (1.8 percent per year) is below the actuarially neutral level of
34 percent and should be increased to at least that level. Hungary, Spain and Italy
have for instance a penalty of 56 percent per year. Also, reducing the tax exemption
level for pension income to that of regular wage income would eliminate a distortion
in favor of early retirement.

Measures should also be taken to reduce the tax burden on labor. The reduction of
health contributions by 2 percentage points (with its revenue impact offset by an
increase in VAT) in 2012, a so-called fiscal devaluation, is a step in the right
direction and should help boost the demand for labor. The government could also
consider increasing the zero VAT tax rate (which is not compatible with EU laws) to
the 10 percent reduced rate (rather than 5 percent as currently envisaged). This would
allow a further reduction in labor taxation. Raising property taxes could also help
rebalance the tax structure away from labor in a revenue-neutral way, although the
proceeds of such tax is likely to be low in the short-term given the need to first
improve the land and property register.

Several changes in the Labor Law would reduce the hiring and firing costs, and
notably: (i) relax the conditions for dismissal, notably for poor performance, for
collective dismissal and for some categories of protected workers in case of justified
business reasons; (ii) allow firms to opt out from onerous sector-level collective
agreements; and (iii) decrease the maximum amount of compensation paid to a
wrongfully dismissed worker from the current 18 months of salary to a more
affordable 6 months.
 19

Table 1. Croatia Doing Business Indicators

Croatia as a Croatia's as
percent of a percent of
2012 as a the regional OECD
percent of average, average,
Areas Measures 2005 2012 2012
Starting a Business Number of procedures 54.5 100.8 113.4
Days required 24.1 43.0 56.2
Cost as a share of income per capita 52.8 103.9 184.1
Paid in minimum capital as a share of income per capita 54.1 128.4 97.9
Dealing with construction Number of procedures 52.2 56.7 86.9
1 Days required 81.3 148.2 208.7
Permits
Cost (% of income per capita) 60.6 124.7 1293.6
Registering property Number of procedures 100.0 88.2 104.0
Days required 10.9 348.9 339.4
Cost (as a % of property value) 100.0 213.4 114.5
1
Protecting Investors Extent of disclosure index (0-10) 100.0 14.5 16.4
Extent of director liability index (0-10) 100.0 119.3 97.5
Ease of shareholder suits index (0-10) 100.0 98.4 89.0
Strength of investor protection index (0-10) 100.0 69.7 66.8
1
Trading across Borders Documents to export (number) 100.0 99.3 160.7
Days required to export 76.9 68.7 191.4
Cost to export (US$ per container) 108.3 68.4 126.0
Documents to import (number) 100.0 100.6 165.3
Days required to import 88.9 51.0 148.9
Cost to import (US$ per container) 98.3 55.2 108.8
Enforcing Contracts Number of procedures 100.0 101.4 120.9
Days required 100.0 143.4 108.3
Cost (% of claim) 100.0 48.1 70.0
Resolving insolvency Recovery rate (cents on the dollar) 103.1 88.8 43.6
Years required 100.0 112.2 179.3
Cost (% of estate) 100.0 119.3 164.9
1. Percent of 2006
Source: Doing Business report 2012, World Bank

35. Reforms to improve the business environment should aim at improving the legal
and regulatory framework in order to increase investment. While some progress has
been made since 2005, the time and costs of the procedures for dealing with construction
permits and property registration remain significantly above the levels in Croatias peers. It is
the time to register the new construction or property in the Land Registry that accounts for
the longest delay (respectively 120 and 60/80 days). The planned digitalization and update of
the land registry and cadastre should therefore be accelerated. Barriers to investment at the
local government level should also be removed. Rules regarding the disclosure of conflict of
interest as well as investor protection should also be improved. It is also urgent to strengthen
the insolvency procedures and fasten the enforcement of judicial decisions. It takes about 50
percent more time to enforce a contract in Croatia compared to its peers due to long delay in
the judicial system, while resolving insolvency takes about twice the time than in the OECD
countries and the recovery rate is low (see Table 1). According to the 20112012 Global
 20

competitiveness report, the inefficient government bureaucracy is the most problematic

factor for doing business in Croatia, while Croatias ranking in terms of the quality of its
legal framework, protection of investors and minority shareholders and burden of regulation
is at the very end of the index (111137 out of 142) (Appendix Figure 6B).

36. More rapid privatization and enterprise restructuring would help foster
competition. Privatization plans should be accelerated, including for the still unresolved
shipyard companies, and a clear strategy put forward for liquidating or selling the assets
owned by the Asset Management Agency. The launching of the restructuring of the railways
company is welcomed and should be pursued further, while the electricity and gas markets
should be liberalized further.

37. Fiscal consolidation efforts will need to be continued in the medium-term.

Sustained fiscal consolidation will help improve the access and cost of financing both for
public and private entities and will facilitate a reduction of the tax burden on labor, thereby
encouraging higher investment.

38. Further efforts should be applied to raise government efficiency. The

governments intention to tackle corruption and implement a fiscal consolidation will help
reduce wasteful and inefficient government spending. Government efficiency could be
further improved by: (i) a rationalization of the structure of government operations, involving
a comprehensive functional review of the size, functions and staffing of all government
organizations; (ii) a reform of the salary formula to establish a tighter link between
performance and salary, eliminate the seniority bonus and align wages at all levels of
government; (iii) outsource non-core functions, such as transport, security, mail, cleaning,
catering and maintenance to improve efficiency and generate fiscal savings.

F. Possible Impact of the Reforms

39. Quantifying the impact of structural reforms on growth is far from trivial. Most
empirical studies find a positive long-term effect of labor and product market reforms on
total factor productivity, growth and employment. However, the impact of the reforms varies
widely as it depends on their specifics, the interactions between product and labor market
institutions, the macroeconomic environment in which the reforms take place, and the
timeframe as short-term effects may be smaller or even negative due to the cost and time of
resources relocation and restructuring.

40. Calculations based on the growth accounting exercise conducted in Section A

suggest that increasing participation rate and employment rate could help to lift GDP
growth substantially. If Croatias participation rate were to increase in the next eight years
 21

to 70 percent as in the Czech Republic, GDP growth would increase by about 1 percent. This
would in turn require an increase in investment to GDP ratio by 1 percentage point9.

41. Growth regressions show that in Croatia, structural reforms have the potential
to increase economic growth significantly by improving productivity. Using the model in
Vamvakidis (2008), increasing the economic freedom index to the level of Estonia (the best
performer in emerging Europe) over the next five years would boost average annual growth
by 0.9 percentage points.10 Reaching the average level of eastern European countries would
boost growth by close to 0.4 percentage points. This would be mainly achieved by improving
labor market flexibility and the efficiency of the legal framework and government spending,
the areas where Croatia ranks the lowest. Moore and Vamvakidis (2007)11 who have
estimated a growth model for Croatia also show that improving the economic freedom index
and the cost of starting new business to the average level of CEE countries, the euro area, or
Ireland would increase average annual growth by about 0.4, 0.5, and 0.8 percentage points,
respectively.

42. In addition, the impact of these reforms would be magnified by their impact on
investment and FDI. If the investment to GDP ratio is increased from its current level of
close to 22 percent to 25 percent12 (the minimum level according to the Spence Report and
also the average level in Slovakia, Slovenia, Czech Republic, Bosnia, Latvia in 200008),
possibly through attracting more FDI, this would boost annual GDP growth by an additional
0.3 percentage points (the models in Vamvakidis (2008) and Moore and Vamvakidis (2007)
give similar results).

9
Assuming that the unemployment rate would remain broadly the same, this scenario would imply an increase
in employment by about 19 percent. Assuming a constant capital to labor ratio, this would require an average
increase of the capital stock by 2.2 percent per year, leading to an increase in investment to GDP ratio by
1 percentage point over these years.
10
The specification of his model is Real per capita GDP growth = 11.00 1.38*(log per capita GDP)
7.05*(age dependency rate) + 0.13*(investment to GDP ratio) + 0.02*(university enrollment ratio)
0.015*(inflation rate) + 0.07*(FDI ratio) + 0.59*(economic freedom) + 0.86*(change in economic freedom).
11
The specification of this model is Real GDP per capita growth = 0.98 +1.88*(dummy for SEE and CEE)
0.49*(initial real GDP per capita) 0.43* (population growth) + 0.14*(investment to GDP ratio)
0.02*(inflation rate) + 0.001*(credit to private sector/GDP) + 0.43*(index of economic freedom) 0.03*(cost
of business start-up procedures in % of GNI per capita.
12
Achieving such a level in 8 years would require an average annual increase in the capital stock by about
2.4 percent and an annual increase in gross fixed capital formation by about 3.4 percent. In this scenario, the
capital stock would increase by about 21 percent after eight years. Depending on the capital intensity of output,
this could potentially generate further employment growth (above the one implied by the 70 percent
participation rate), and thus even higher GDP growth.
 22

43. The total impact of these reforms could be significant. While not all of these
effects may be strictly additive and the quantification of the impact of structural reforms on
growth is subject to large estimation errors, this exercise nevertheless suggests that the
impact of structural reforms on GDP growth in Croatia could be substantial and exceed
2 percent in the medium to long-term.

Impact on medium-term annual growth rate

Macroeconomic reforms 1.4
Higher participation rate (target: 70%, as CZE) 1.1
o/w: Increase in employment growth 1
Increase in capital to keep K/L ratio constant 0.1
Higher domestic investment (from 23 to 25% of GDP, as SVK, SVN, CZE, LVA) 0.3
Structural reforms (target: level of CEEC/EST) 0.4 - 0.9
Total effects 1.8 - 2.3
References: Vamvakidis (2008), Moore and Vamvakidis (2007)

G. Conclusions

44. Croatias pre-crisis growth model relied on capital accumulation in the non-tradable
sector, which led to low productivity gains and export growth compared to its peers.
Achieving reasonable medium-term growth requires a fundamental change in the economic
policies and institutions.

45. The policy recommendations coming from the reviewed three sources of
economic thought are very similar. To boost medium-term growth, Croatia needs to
(i) increase work incentives to boost labor force participation and improve labor market
flexibility, which will help the economy regain competitiveness and support export-led
growth; (ii) improve business environment, via easier regulations, better legal framework,
and more efficient administration, and foster competition by accelerating privatization and
enterprise restructuring, to attract capital to the tradable sectors and boost productivity; and
(iii) continue the fiscal consolidation efforts in the medium term to reduce macroeconomic
risks and improve the access and cost of financing. Empirical evidences suggest that the
impact of those reforms could be quite substantial, raising annual GDP growth by about
2 percent in the medium to long term.
 23

References

Everaert L., and W. Schule, 2006, Structural Reforms in the Euro Area: Economic Impact
and Role of Synchronization Across Markets and Countries, IMF Working Paper
No. 06/137 (Washington: International Monetary Fund).

Hausmann, R., Rodrik D., and Velasco A., 2005, Growth Diagnostics, Working Paper.
Available via Internet: www.hks.harvard.edu/fs/rhausma/publication.htm.

International Bank of Reconstruction and Development (IBRD), 2008, The Growth

ReportStrategies for Sustained Growth and Inclusive Development by the
Commission on Growth and Development (Washington).

Goldman Sachs, 2012, Our 2011 GES: A sharper Signal for Growth, Goldman Sachs
Global Economics, Commodities and Strategy Research.

Moore D. and Vamvakidis A., 2007, Economic Growth in Croatia: potential and constraints,
IMF Working Paper No. 07/198 (Washington: International Monetary Fund).

Mourre G., 2009, What Explains the Differences in Income and Labour Utilization and
Drives Labour and Economic Growth in Europe? A GDP Accounting Perspective,
Economic Papers 354, January 2008, European Economy, European Commission.

Organization for Economic Co-operation and Development, 2012, OECD Economic

Surveys Euro Area, (Paris).

Vamvakidis A., 2008, Potential Growth Estimates in Emerging Europe Based on a Growth
Model, Box 8 of Regional Economic Outlook: Europe, April (Washington:
International Monetary Fund).

Schadler, S., Mody, A., Abiad, A.; Leigh, D., 2007, Growth in Central and Eastern
European Countries of the European Union, IMF Occasional Paper 252
(Washington: International Monetary Fund).
 Change in real GDP per capita, 2000-
2008, annualized (percent)

0
2
4
6
8
10

-8
-6
-4
-2
0
1
2
3
4
5
6
7
8
9
10

0
1
2
3
4
5
6
7
8
9

0
Latvia Portugal
APPENDIX

Greece Mexico
Venezuela Malta

Source: WEO
Romania El Salvador
Lithuania Cyprus

MDA
Croatia Brazil
Slovenia Venezuela
Ukraine Uruguay

UKR

ALB
Estonia Costa Rica

5000
Cyprus Macedonia

ECU
BIH THA
Portugal Chile

PER

SLV
DOM
SRB
Hungary South Africa

COL
ROM
BGR

MNE
Montenegro Colombia

ZAF
PAN
El Salvador Argentina

RUS

TUR
Bulgaria Hungary

LVALTU
Czech Republic Dominican Republic

BRA DMA
MKDCRI URY
VEN
MYS
Serbia Ecuador

EST

CHL

10000
Russia

ARG
Greece

POL
Malta Turkey

HRV

MEX
Mexico Czech Republic
24

SVK
Bosnia Croatia

HUN
South Africa Slovenia
(percent)

Slovak Republic Peru

(percent)
Costa Rica Poland
Macedonia Thailand

CZE

15000
Ecuador Bosnia

GDP per capita, PPP, US dollar, 1999

Chile Panama
Turkey Montenegro
Colombia Serbia
SVN
Thailand Albania
Brazil

PRT
Slovak Republic
GRC

Moldova Moldova
Albania MLT Estonia

20000
Poland Bulgaria
CYP

Dominican Republic Romania

Peru Russia
Panama
Middle-Income Countries: Change in real GDP per capita, 20008, annualized

Ukraine
Figure 1. Croatia: Relative growth performance, 2000-2011

Belarus Latvia

Middle-Income Countries: Change in real GDP per capital, 2009-2011, annualized

Argentina Lithuania
Uruguay Belarus
China China
25000
 0
1
2
3
4
5
6
7

-2
-1
0
1
2
3
4

0.5
1.5
2.5
3.5
4.5

0
1
2
3

-1
0.5
1.5
2.5
3.5

-0.5
Brazil Uruguay
Portugal Albania
Turkey Brazil
Costa Rica Argentina
cyprus Hungary
Thailand
malta Serbia
Colombia
Colombia Romania
El Salvador
Mexico Portugal
South Africa
Ecuador Ukraine
Malaysia
Venezuela Lithuania malta
South Africa Bosnia Portugal
Chile Czech Republic Peru
El Salvador El Salvador cyprus
Argentina Uruguay Mexico
greece China Russian Federation

Source: WEO & IMF Staff Computations

Uruguay Poland Serbia
Hungary Croatia Poland
Slovenia malta Venezuela
Croatia Slovenia Turkey
Mexico Panama
25

Poland
Czech Republic Russian Federation Ukraine
Dominican Republic macedonia Dominican Republic
greece greece
Bosnia
Estonia Czech Republic
Bulgaria
Slovak Republic Costa Rica
Panama
latvia Chile
Thailand
Slovak Republic
Peru Malaysia
Ecuador
Estonia Thailand
Hungary
Slovak Republic Bulgaria
Romania
Malaysia Dominican Republic
Croatia
latvia Chile Slovenia
Serbia Argentina Bulgaria
Turkey Peru Montenegro
Middle-income countries - Contribution of labor to growth, 2000-2008 (percent)
Middle-income countries - Contribution of capital to growth, 2000-2008 (percent)

Albania South Africa Bosnia

Panama

Middle-income countries - Contribution of total factor productivity, 2000-2008 (percent)

Romania Lithuania
Lithuania cyprus Albania
Russia Venezuela latvia
Figure 2A. Middle-Income Countries: Growth Accounting, 2000-08

Ukraine Ecuador Estonia

China Colombia China,P.R.: Mainland
 0
1
2
3
4
5
0
1
2
3

-4
-3
-2
-1
-4
-3
-2
-1
0
1
2
3
4
5

0.5
1.5
2.5
3.5
Romania Serbia 4.5
Ukraine
Venezuela latvia
malta
latvia Lithuania
Portugal
greece Estonia
greece
Russian Federation greece
El Salvador
Croatia Bosnia
latvia
Slovenia Bulgaria
Estonia
Ukraine Croatia
Lithuania
cyprus Portugal
Hungary
Hungary Slovenia
Slovenia
El Salvador South Africa
Thailand
Mexico Slovak Republic
Czech Republic
Lithuania Hungary
Slovak Republic
Bulgaria Ukraine
cyprus

Source: WEO & IMF Staff Computations

Czech Republic Czech Republic
Bosnia
Romania
malta Mexico
Albania
Costa Rica Malaysia
cyprus
Portugal Croatia
Russian Federation
Romania
26

Estonia
Uruguay
Turkey Brazil
Chile
Colombia Turkey
Dominican Republic Dominican Republic
Panama
Poland Bulgaria
Ecuador
Mexico Costa Rica
Slovak Republic Venezuela
South Africa Uruguay
El Salvador South Africa
Malaysia macedonia
Bosnia & Herzegovina Albania
Brazil Poland
Poland Ecuador Venezuela
Chile malta Russian Federation
Thailand Thailand Ecuador
Albania China Montenegro
Brazil Costa Rica Serbia
Middle-income countries - Contribution of labor to growth, 2009-2011 (percent)

Peru
Middle-income countries - Contribution of capital to growth, 2009-2011 (percent)

Peru Argentina

Middle-income countries - Contribution of total factor productivity, 2009-2011 (percent)

Serbia, Republic of Argentina Colombia
Argentina Colombia Chile
Dominican Republic Malaysia Peru
Figure 2B. Middle-Income Countries: Growth Accounting, 2009-11

Uruguay Turkey Panama

China,P.R.: Mainland Panama China,P.R.: Mainland
 0
1
2
3
4
5

-5
-4
-3
-2
-1
0
1
2
3
4
5
6

-4
-3
-2
-1
greece Albania
Serbia Turkey
Bosnia Uruguay
Croatia Hungary
Lithuania Portugal
Bulgaria Romania
Portugal

population
Ukraine

i
population

F
Slovenia Serbia, Republic of

labor force/pop

employment/LF
latvia Czech Republic
Estonia Croatia
South Africa China
labor force/pop 15-64

Hungary Slovenia
Slovak Republic Lithuania
Czech Republic Russian Federation
macedonia greece
Colombia Mexico
Romania Poland
Uruguay South Africa
Ukraine Thailand
employment/LF
27

Albania El Salvador
share of 15-64 pop

cyprus macedonia
Poland

2009-2011
malta

Source: WEO, World Bank WDI, IMF staff computations

2000-2008

Chile Bosnia
Thailand Estonia
Venezuela Slovak Republic
Russian Federation latvia
Decomposition, 2000-11

Ecuador Malaysia
Mexico Dominican Republic
Brazil Chile
malta Argentina
China Bulgaria
Peru Peru
El Salvador Colombia
Dominican Republic cyprus
Argentina Venezuela
Figure 3. Middle-Income Countries: Employment Growth

Malaysia Panama
Costa Rica Costa Rica
Turkey Ecuador
Panama Brazil
Montenegro Montenegro
 0
10
20
30
40
50
60
0
10
20
30
40
50
60
70
80
Albania Portugal
Bosnia Turkey
Turkey Malta
Portugal Spain

Source: Eurostat
Romania Iceland
Montenegro Belgium
Czech Republic Albania
Slovak Republic Ukraine
Italy Greece
Malta Ireland
Austria Cyprus
Poland Netherlands
Croatia Italy
Slovenia Luxembourg
Hungary Finland
Netherlands France
Latvia UK
Greece Russia
28

Bulgaria Denmark
Germany Lithuania
Luxembourg Sweden
Switzerland Estonia
France Norway
Denmark Bulgaria
Sweden Switzerland
UK Germany
Spain Romania
Share of labor force with tertiary education
Share of labor force with secondary education

Iceland Croatia
Ireland Slovenia
Cyprus Latvia
Norway Austria
Finland Hungary
Figure 4. Croatia: Education Level of the Labor Force

Estonia Poland
Belgium Montenegro
Lithuania Czech Republic
Russia Slovak Republic
Ukraine Bosnia
 0
5
10
15
20
25

-5
Change in export to GDP ratio,

-1
0
20
40
60
80
100
120
2000-2011 (percent)
Greece
Brazil Venezuela
Colombia Turkey
Greece South Africa

Source: WEO
Argentina

5
15
25
35
45

-25
-15
Slovenia
Peru

-5 0
Ecuador
Turkey Argentina
Albania

2011
Russia

PRT
Uruguay
2000-2008

El Salvador
El Salvador
Portugal
Mexico
Serbia Mexico

1
South Africa Brazil

MEX
Portugal Malaysia
Colombia

CYP
Venezuela
Thailand

SLV
MLT VEN
China
2009-2011

2000-2011
Dominican Republic Lithuania
China

GRC
Ecuador

2
Bosnia Poland

DMA
Romania Peru
Russia Uruguay

HRV
HUN

BRA
Dominica Latvia
29

CRI
Poland Hungary

MKD
ZAF
2000-2011

SVN
Montenegro Dominican Republic

3
Chile Ukraine

MYS
CHL
Croatia Bosnia

CZE
Costa Rica Costa Rica

ECU
Macedonia Romania
Latvia

COL TUR
Croatia

URY

DOM
Moldova Macedonia
Cyprus

4
Serbia
Ukraine Albania

BIH SRBTHA
Bulgaria

ARG POL
Czech Republic

PER
Lithuania Slovak Republic

LVA
Slovenia

Change in real GDP per capita, 2000-2011, annualized (percent)

Moldova

EST
ROM
Belarus Chile

PAN
Thailand

SVK

5
Dominica
Figure 5. Croatia: Openness to the global economy

ALB
Czech Republic

BGR
Panama
Hungary

Middle-Income Countries: Export and growth performance, 2000-2011

Estonia

RUS
Panama

UKR
Middle Income Countries - Export to GDP ratio, 2000-2011 (percent)

LTU
Estonia Malta
Middle-Income Countries: FDI inflows over GDP, 2000-2011 (percent)

Slovak Republic Bulgaria

Malta Cyprus

MDA
6
Malaysia Montenegro
 30

Figure 6A. Croatia: Business Environment, 201112

0 20 40 60 80 100 120 0 20 40 60 80 100 120

LVA EST Global Competitiveness Ranking 2/

Doing Business Ranking 1/
MKD CZE
EST POL
LTU LTU
SVN HUN
NMS SVN
SVK MNE
HUN NMS
MNE LVA
BGR SVK
POL BGR
CZE HRV
ROM ROM
HRV ALB
ALB MKD
SRB SRB
BIH BIH

0 50 100 150 0 50 100 150

0 20 40 60 80 100 120 140 0 20 40 60 80 100 120

CZE EST
Business Sophistication Ranking 2/ Economic Freedom Ranking 3/
SVN LTU
EST CZE
LTU MKD
POL HUN
SVK SVK
HUN LVA
MNE ALB
LVA NMS Avg.
NMS BGR
ALB ROM
HRV POL
BGR SVN
ROM MNE
MKD HRV
BIH SRB
SRB BIH

0 50 100 150 0 50 100 150

Sources: World Bank, Doing Business; World Economic Forum, Global Competitiveness Report; Heritage Foundation,
Economic Freedom Index; and IMF staff calculations.
1/ Covers the period June, 2010 through May, 2011. Rank out of 183 countries.
2/ Rank for 201112. Ranking out of 142 countries.
3/ Rank as of 2012. Ranking out of 184 countries.
 31

Figure 6B. Croatia: Business Environment, Components, 2005-2012

Heritage Foundation: Croatia Economic Freedom Rankings

Labor Freedom Rank
Freedom From Corruption Rank
2005
Property Rights Rank
Financial Freedom Rank 2012
Investment Freedom Rank
Monetary Freedom Rank
Government Spending Rank
Fiscal Freedom Rank
Trade Freedom Rank
Business Freedom Rank
Overall Rank

0 20 40 60 80 100 120 140 160

Source: (1)
World Bank: Doing Business Report
Protecting Investors
Trading Across Borders
2011
Starting a Business
Resolving Insolvency 2012
Registering Property
Paying Taxes
Getting Electricity
Getting Credit
Enforcing Contracts
Dealing with Construction Permits

0 20 40 60 80 100 120 140 160

Source: (2)
Global Competitiveness Rankings: Croatia
Labor market efficiency Rank
Goods market efficiency Rank
Institutions Rank
Business sophistication Rank
Financial market development Rank 2012
Innovation Rank
Market size Rank
Macroeconomic environment Rank
Higher education and training Rank
Health and primary education Rank
Infrastructure Rank
Technological readiness Rank
0 20 40 60 80 100 120 140
Source: (3)

(1) Heritage Foundation Economic Freedom Index 2012, 2005; Rank: Out of 179 Countries, 1 = Best Score
(2) World Bank Doing Business Report 2011-12; Rank: Out of 188 Countries, 1 = Best Score
(3) Global Competitiveness Index Report 2011, 2012; Rank out of 142 Countries, 1 = Best Score
 32

Figure 7. Croatia: Access to international financing, 2000-2008

12 45
The rate of capital accumulation was relatively ...or its GDP level.
Change in capital stock per capita, 2000-

high in Croatia given its initial capital stock...

GFCF/GDP ratio, average 2000-2008

10 CHN LVA 40
CHN
2008, annualized (percent)

8 EST 35
BGR
BLR

(percent)
ALB
6 SVN 30 EST
LTU HRV ALB LVA
CHL
CRI BIH SVK CZE SVN
4 POLHUN 25 THA
GRC ROM HRV PRT
COL MDA BGR
TUR
BIHZAF
URY MEX SVK CZE UKR
ECUMNE LTU
MYS HUN
DMA
PER ROM PRT VEN
CHL GRC
2 20 PER CRI MEX
POL MLT
MDAUKR ECU CYP COLTURARG
RUS
PAN CYP
MKDVEN ARG SRB
ZAF
THA MYS
RUS SLVBRA
URY
0 BRA 15
0 10000 20000 30000 40000 50000 0 5000 10000 15000 20000 25000
GDP per capita, PPP, US dollar, 1999
Real capital stock per capita, US dollar, 1999

1800
800 CDS Spreads (Basis points)
EMBI Eurobond Spreads (Basis points)
700 1500 Croatia
600 Bulgaria
Croatia 1200 Romania
500 Composite Turkey

400 Europe 900

300 600
200
300
100

0 0
2000 2001 2002 2003 2004 2005 2006 2007 2000 2001 2002 2003 2004 2005 2006 2007

60
FDI Capital Inflows
50 (Percent of 2000 GDP; average of 200008)
40 Portfolios
30 Others
20 Total
10
0
-10
-20
-30
-40
Hungary

Estonia
Slovak Republic
United Kingdom

Moldova
Croatia
Belgium

Iceland
Russia

Bosnia

Romania
Netherlands

Ukraine

Slovenia
Finland
Germany

Portugal

Greece
Cyprus
Switzerland

Austria
France

Poland

Bulgaria
Lithuania
Norway

Albania
Macedonia, FYR
Turkey

Czech Republic
Malta
Sweden

Ireland

Latvia
Denmark

Montenegro, Rep. of
Italy

Spain

Source: Bloomberg;Penn Tables; World Economic Outlook database; and IMF staff calculations.
In percent of 2003 GDP; average of 200310.
 33

Figure 8. Croatia: Access to domestic financing

20 8
Croatia - Real average lending rate, 1997-2011 Croatia - Average Real deposit rate, 1997-2011
(percent) (percent)
6
15

10
2

5 0

-2
0

-4
ST corporate
-5 ST household kuna time deposits
LT corporate FX indexed -6 FX time deposits
LT household FX indexed Kuna sigh deposits
Real GDP growth
FX sigh deposits
-10
-8
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011

1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
50 35
Middle-income countries - Real lending rate, Middle-Income countries: Difference between
2000-2011 (percent) 30 real lending rate and real GDP growth rate,
2000-2011 (percent)
40 44.4%
25

20 2000-2008
30 2009-2011
15

20 2000-2008 2009-2011 10

5
10
0

-5
0
-10

-10 -15
Czech Republic

Dominica
Malaysia
Russia

Costa Rica
Colombia

Macedonia
Romania
Moldova
Estonia
Malta

Latvia

Argentina
Thailand

South Africa
Mexico

Chile
Bulgaria

Brazil
Hungary

Croatia

Ukraine
Panama

Peru
China

Albania
Serbia

Czech Republic
Malaysia
Russia

Costa Rica
Dominican Republic

Macedonia
Romania

Colombia
Estonia

Moldova
Venezuela
Latvia

Malta

Argentina
Thailand
Slovenia

South Africa
Mexico
Slovak Republic

Chile

Brazil
Bulgaria

Hungary

Australia

Croatia

Iceland
Peru
Panama
China

Italy
Serbia

Albania

Source:National Bank of Croatia, IFS.

 34

Figure 9. Croatia and other Eastern European Countries: Structure of

production by branches
31 9
Share of industry (excluding construction) in VA Share of construction in VA (percent), 2000-2010
29 (percent), 2000-2010 8
27 7
6
25
5
23
4
21 3
19 2
17 1
15 0

25
Share of financial intermediation and real estate in 25
VA (percent), 2000-2010 Share of public services in VA (percent), 2000-
2010
20
20

15 15

10 10

5 5

0 0

14 35
Share of agriculture in VA (percent), 2000-2010 Share of trade, hotel and transport in VA (percent),
30 2000-2010
12

10 25
8 20
6 15
4
10
2
5
0
0

Source: Eurostat
 0
1
2
3
4
5
6
0
5
10
15
20
25
30
35
40
45
50
Netherlands Norway
Italy Greece
Ireland Ireland
Hungary Cyprus
Netherlands
Norway
Denmark
Lithuania Portugal

Source: Eurostat.
Iceland Austria
Poland Finland
Estonia Estonia
Denmark Latvia
Croatia
Greece
Iceland
Malta Germany
Germany
(percent of total)

Lithuania

(percent of total)
Slovakia Sweden
Slovenia Malta
Croatia Slovenia
GFCF in manufacturing, 2004-2009

Italy
Portugal
Poland
United Kingdom Hungary
Finland Czech Republic

GFCF in financial and insurance activities, 2004-2009

Belgium Slovakia
Romania Romania
35

0
5
10
15
20
25
30

0
2
4
6
8
10
12
14

Investment is measured as Gross Fixed Capital Formation (GFCF)

Germany
Ireland Iceland
Netherlands
Finland Italy
Denmark
Greece
Figure 10. Croatia: Investment Structure1

Slovakia Estonia
Malta
Cyprus
Austria Lithuania
Norway
Hungary Latvia
Czech Republic
Sweden
Poland Sweden
(percent of total)

Portugal
2004-2009 (percent of total)

Italy
Slovenia Czech Republic
GFCF in construction, 2004-2009

Belgium
Iceland Poland
GFCF in trade, transport, accomodation and food,

Estonia
Lithuania
Latvia Croatia
Croatia
 36

Figure 11. EU and US: Average TFP growth by sectors, 95-2007, annualized
(percent)

Non-market services
Sweden
Real estate activities
US
Hotels and restaurants Average SV, HU, CZ
EU
Finance and business, except real estate

Distribution (trade & transport)

Construction

Electricity, gas and water supply

Total manuf acturing, excluding electrical

Electrical machinery, post and
communication services
-6 -4 -2 0 2 4 6 8 10 12 14
Source: EU Klems Database
37
 38

II. CROATIAEXPORT PERFORMANCE, WAGES, AND PRODUCTIVITY1

The note examines various price measures from a cross country perspective with specific
focus on the link between productivity growth, wages and export performance. The result of
this analysis suggests that Croatias high wage level is a major drag on export performance.
Disaggregated analysis of export products suggest that wage growth has been broadly in line
with productivity and alludes to the historically high level of wages, together with weak
business environment, as key constraints on competitiveness.

A. Introduction

1. Croatias pre-crisis growth performance was built on weak fundamentals.2 The

robust growth performance recorded from 200208 was driven by abundant capital inflows,
which fueled a credit boom, spilled over into large current account deficits, and resulted in a
buildup of foreign liabilities. External funding was mainly in the form of debt-creating flows,
with the majority of FDI going to the financial sector. This had the effect of further tilting the
structure of the economy away from the tradable sector.

2. Sustainable long term growth would require a rebalancing of the economy from
domestic to external demand. Domestic demand is likely to remain subdued over the near
term as worldwide deleveraging from the high pre-crisis level is likely to moderate the extent
of future capital inflows, while domestic deleveraging is likely to temper the demand for
credit. In this context significant rebalancing through expansion of the tradable sector is
needed to promote sustained economic growth.

3. Croatias export performance over the past decade suggests that external
competitiveness is relatively weak and serves as a binding constraint on growth. Weak
competitiveness is largely due to relatively high labor cost. This along with existing
structural weaknesses suggests that urgent reforms to facilitate wage adjustment and improve
the business environment are needed to improve competitiveness and export performance.

B. Key Findings

4. Movements in ULC and productivity at the disaggregated level suggest that

increases in unit labor cost from 200008 were not out of line with the regional average.
In addition the gaps between productivity and wage growth (measured by difference between
productivity growth and wage growth) were broadly in line with the sample average. Despite

1
Prepared by Reginald Darius
2
The discussion of Croatias growth model follows the analysis of growth experiences in Eastern Europe
detailed in Atoyan, R., 2010, Beyond the Crisis: Revisiting Emerging Europes Growth Model, IMF Working
Paper 10/92 (Washington: International Monetary Fund).
 39

the growth in wages at the individual commodity export level, which is broadly in line with
its comparators, Croatias export performance in almost every product was at the lower end
of the range of the countries in the sample. This represents a slight puzzle as growth in ULC
which was broadly in line with that of comparator countries would imply that
competitiveness was not significantly eroded during the past decade.

5. The paper finds that the wage differential between Croatia and comparator
countries has declined over the past decade, however the wage level remain above the
sample average, which suggest that weak export performance may be affected by the
traditionally high level of wages, combined with numerous weaknesses in the business
environment. With external demand likely to be lower than in the pre-crisis period, at least in
the near-term, further reducing the wage gap between Croatia and its regional peers appears
even more crucial than in the past to improve export performance.

6. The remainder of the paper is organized as follows. Section C examines

developments in the external sector and particularly the trade deficit and the link between
current account deficit and the buildup of vulnerabilities. Section D examines recent export
performance, while section E examines wage, productivity, and export growth by
commodity. The final section presents some conclusion and policy issues to consider.

C. Current Account Balance and External Vulnerabilities

7. Relatively persistent current account deficits alongside weak export

performance are symptoms of an underlying competitiveness problem. During 200008,
the current account deficit averaged 5.6 percent of GDP. The trade deficit averaged about
20 percent of GDP, with import growth buoyed by rapid increase in domestic demand during
the boom period exceeding export growth. During that period the savings investment
balance deteriorated due largely to an increase in investment in the non tradeable sector. The
subsequent improvement in the current account deficit, during the period of severely
weakened economic activity was due to a significant contraction in import demand as exports
also plunged during the crisis but recovered at a faster rate.

8. The current account deficit was mainly financed by external debt. This resulted
in a significant build up of vulnerabilities, which exposed the economy to financing risk.
During the period (20002008) external debt rose from 52 percent of GDP to about
80 percent of GDP. A large proportion of the increase in debt was due to borrowing by
banking sector, which was used to finance the domestic consumption boom rather than
investment.
 40

9 9 12 12
Non-debt Creating Flows (% of GDP, 200011 average) Debt-Creating Flows (% of GDP, 200011 average)
8 8
FDI and changes in 10 Balance on Financial & 10
7 reserves. 7 Capital Accounts, less FDI

6 6 8 8

5 5
6 6
4 4
4 4
3 3

2 2 2 2

1 1
0 0
0 0

-1 -1 -2 -2
SVN HUN LTU UKR ROM LVA POL HRV SVK CZE EST BGR UKR SVN CZE POL SVK ROM LTU HUN LVA EST BGR HRV

Sources: IMF, World Economic Outlook; and IMF staff calculations.

D. Export Performance and Market Share Analysis

9. Croatias export performance has been 120 10

weak. The contribution of external demand to Exports and Recovery, 2011

growth was negative during the boom years, 100 Exports of Goods & Services
(% of GDP)
8

20012008. Following the economic crisis the 80

Real GDP growth (y-o-y %
6
change, rhs)
contribution of external demand to growth
improved with positive contributions in 2009 and 60 4

2010 due in part to the collapse in domestic

40 2
spending.
20 0
10. Croatias rate of export growth was
amongst the slowest in this sample of Eastern 0
ROM HRV POL LVA BGR CZE LTU HUN EST
-2

European countries from 200020083. Total 15

Contribution to Real GDP (Percent)
15

export growth averaged about 15 percent the 10 10

lowest rate recorded by any of the countries in this
group. During the economic crisis when most 5 5

countries suffered a significant collapse in export

0 0
growth, Croatia was amongst the hardest hit.
Export growth contracted by an annual average -5 -5
rate of almost 4 percent in 20092011, the worst Domestic demand
External demand
performer among its peers. -10 -10
Real GDP growth
-15 -15
2000 2002 2004 2006 2008 2010

Sources: Haver; and IMF staff calculations.

3
Countries included in the analysis are Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania,
Poland, Romania, and Ukraine.
 41

30 14
Average Export Growth (2000 - 2008) Average Export Growth (2009 - 2011)
(Percent) 12 (Percent)
25
10
20 8

6
15
4
10 2

0
5
-2
0 -4
HRV HUN EST CZE LVA BGR UKR POL ROM LTU HRV HUN POL CZE UKR ROM LVA BGR LTU EST
Source: WEO, and IMF Staff calculations.

11. The EU is Croatias main commodity export market. Croatias share of EUs
imports remained relatively stagnant over the past decade. About 60 percent of Croatias
exports are destined to the EU. The EU also serves as the main market for the other countries
in the samplewith the exception of Ukrainepurchasing on average in excess of
60 percent of their export goods. Croatias share of the EU market is relatively small and
falls within the lowest percentile relative to the other countries in the sample. Furthermore
Croatia has made limited gains in improving on its percentile ranking over the past decade.
90 90 2.50 2.50
Average Export Share to E.U., 200511 Market Share of the E.U.
(Percent of total exports) (Exports to the E.U. in percent of E.U. imports)

2.00 2.00
Croatia
60 60 Median
1.50 Max (95th percentile) 1.50
Min (5th percentile)

1.00 1.00
30 30

0.50 0.50

0 0 0.00 0.00
UKR BGR HRV LTU LVA EST ROMHUN POL CZE 2000 2002 2004 2006 2008 2010

Sources: IMF, Direction of Trade statistics; and IMF staff calculations.

12. Croatia was also unsuccessful in making inroads into the non EU market
(Figure 1). The share of world imports accounted for by Croatia was in the lowest percentile
and with minimal change over the past decade. A more disaggregated analysis suggests that
Croatia was able to retain its market share in most markets but made limited strides in
improving its position. A notable exception was the increase in market share to oil exporting
countries, particularly following the onset of the global economic crisis.
 42

13. Commodities export is dominated by intermediate and consumer goods. Over the
past decade, intermediate and consumer goods 150 150
Export Components (Percent of exports)
accounted for about 60 percent of commodity Consumption goods
exports. The contribution of these commodities 120
Intermediate goods
120
Capital goods
has remained remarkably stable. Capital goods Energy and other goods

accounted for about 20 percent of commodity 90 90

exports during that period, suggesting that Croatia
made limited headway in moving to the higher end 60 60
of the export market.
30 30
14. The export sectors did not benefit much
from the strong growth in capital inflows.
0 0
Greenfiled FDI into the tourism sector was 2000 2002 2004 2006 2008 2010
relatively low, while inflows into the manufacturing Sources: Croatian authorities; and IMF staff
calculations.
sector were modest. The majority of the external
inflows made only limited contribution to improving competitiveness. On a cross country
basis the average amount of FDI to the manufacturing sector was lowest in Croatia and this
would partially explain the relatively weak export performance during that period. However
within the manufacturing sector there appears to be limited causal link between FDI and
export growth.
 43

FDI flows into key Export Sectors

(2000-2010) (2007-09) (2004-09)
Croatia Bulgaria Romania Czech Rep.
Proportion of FDI to Manu. 8.53 20.58 31.75 36.38
Proportion of FDI to Hotels 3.62 1.59 0.48 10.37

E. Wages and Export Performance: A Micro Analysis

15. Croatias relatively high wages is a drag on competitiveness. Nominal wages in

the manufacturing sector are high relative to peers and when compared to income and
productivity levels. While productivity levels in Croatias industrial sectors are not low,
wages remain above the level consistent with existing levels of productivity. Not only are
wages high but the overall employee compensation is high in Croatia.

1250 1250 1250 1250

GDP Per Capita and Wages, 2011 Labor Productivity and Wages, 2011
Average monthly gross wage (Euros)
Average monthly gross wage (Euros)

1000
HRV 1000
HRV
1000 1000
POL EST EST
MNE POL
750 HUN SVK 750 MNE
BIH 750 SVK 750
LVA HUN
LVA BIH
ROM RUS
LTU SRB
500 MKD 500 500 RUS MKD LTU 500
SRB KAZ ROM
KAZ
250 BGR 250 BGR
250 250
UKR UKR

0 0 0 0
0 5 10 15 20 0 10 20 30 40 50
Nominal GDP per capita (Thousands of USD) Labor Productivity (Euro area = 100)

Sources: IMF, World Economic Outlook; and IMF staff estimates and calculations.

16. Detailed cross country data on ULC, productivity, wages and exports by
manufacturing sub-sectors provides the basis for a micro assessment of Croatias
export competitiveness. The Vienna institute publishes detailed information on export data
for a number of Eastern European countries including Croatia. The information contained in
this database allows for a micro level analysis of the role of cost and productivity in export
performance. The database includes information on manufacturing products identical to the
2-digit level of ISIC Rev. Code 3 (23 industries) and also total industry (mining and
quarrying, manufacturing, and electricity, gas steam and water supply). The data includes
industrial production by sub-sector, unit labor cost, wages and productivity.

17. This analysis focuses on a selected subset of manufacturing products for which
data is available. Products are chosen based on export value with the threshold of at least
EUR 250 million to the EU market in 2008, the last year for which the relevant data is
available, and a second group of high-end/high-value products is also included. Nine sub-
 44

sectors met the minimum value threshold. In the high-end category five sub-sectors are
included, with electrical machinery falling into both categories.

18. Overall industrial and manufacturing sector data suggest that Croatias annual
average growth in ULC was relatively low (Figure 2). Annual average ULC growth of the
manufacturing sector was well below five percent, only Hungary and Poland recorded a
slower rate of increase. Despite the relatively slow rate of growth in ULC, Croatia recorded
the lowest average annual export growth (less than 10 percent), while every other country
recorded export growth in excess of 10 percent. A similar picture emerges in the case of
industry exports, where labor cost was the third lowest; however, export growth lagged that
of all but four countries in the grouping.

19. At the more disaggregated level there was broad consistency with the trend
observed in the manufacturing sector of relatively low growth in ULC alongside
comparatively weak export performance (Figure 25). This is particularly apparent in the
case of food products, chemical products, electrical machinery and machinery and
equipment. Notable exceptions include apparel, transport equipment and wood products. The
performance of apparel exports appears to have been affected by price competitiveness.
Exports of apparel products registered the third largest decline of the countries in the group
of about 5 percent, while ULC increased by about 7 percent, and the fall in wages was much
lower than then the decline in productivity. Export of transport and equipment registered big
gains, alongside increased ULC of about 5 percent but the positive gap between productivity
and wage growth was relatively high. Export of wood products and textiles also grew at a
comparatively high rate and was supported by productivity gains which far exceeded wage
increases.

20. Croatias performance in high technology export was below average (Figure 6).
With the exception of office machinery and communication equipment -mainly due to the
base effect- export growth in relatively high technology products were generally below par.
Average export growth of both office machinery (about 45 percent) and communication
equipment (about 20 percent) was impressive. However these outcomes should be viewed
with some caution given the small starting position. Medical products registered an average
annual export growth of about 10 percent despite relatively modest growth in ULC and the
very low base. Publishing and printing had a similar pattern, Croatia, despite been the only
country to record an average decline in ULC, recorded the second lowest export growth in
the group.

21. The relative gap between productivity and wage does not appear to exert much
influence on Croatias export performance (Table 1). Despite having a higher gap between
wages and productivity in key export categories, Croatias export growth was lower for total
industry and manufacturing products along with the subgroups; food products, machinery
and equipment, chemical products and publishing and printing. These results are in direct
contrast to what would have been expected. The outcome for wood products was more in line
 45

with the norm, where the larger gap between productivity and wages resulted in a more
favorable export performance. Transport and equipment also provided a non standard
outcome in the opposite direction, where despite wage growth exceeding that of productivity
export performance was better than the average.

Table 1: Export Growth Productivity and Wage Gap (P-W)

Gap Export Growth

Avg. Export HRV Export
Avg. Gap HRV Gap Gap diff. Growth diff
Growth Growth
Transport equip. 2.8 -0.9 -3.8 28.3 53.7 25.4
Office machinery 16.8 -9.8 -26.6 35.6 46.0 10.4
Communication equip. 8.1 -2.8 -10.9 23.8 23.9 0.1
Food products 1.2 2.3 1.1 20.7 15.1 -5.6
Machinery and equip. 6.3 6.5 0.2 21.2 15.0 -6.2
Medical instruments 5.3 2.5 -2.9 19.9 10.1 -9.8
Electrical machinery 3.1 1.9 -1.2 17.7 9.7 -8.1
Total industry 1.5 1.8 0.3 15.9 8.5 -7.4
Manufacturing 2.0 2.2 0.2 15.5 8.4 -7.1
Wood products 1.4 3.4 2.1 5.7 8.0 2.3
Chemical products 3.6 2.2 -1.4 18.4 6.4 -12.1
Textiles 2.7 1.6 -1.0 5.1 5.7 0.6
Publishing and printing 2.1 6.6 4.5 17.0 4.3 -12.7
Apparel 0.2 -2.9 -3.1 -0.9 -5.2 -4.3
Gap measures the difference between productivity growth and wage growth.
The average gap is the average of the difference between productivity and wages of the countries included in the sample
Source: Vienna Institute for International Economic Studies; and IMF staff calculations

22. Export growth is strongly correlated to productivity and ULC growth for a few
low value added commodities. Exports of other transport equipment and electrical
machinery are strongly correlated with both ULC and productivity-although in the case of the
electrical machinery the correlation with productivity growth has the wrong sign (Table 2).
Export growth of textiles, and food and beverage are also strongly correlated with
productivity and ULC growth. This suggests that for some major export categories the
outcome is in line with the expectation that increasing productivity would result in a
significant boost to exports.
 46

Table 2. Export, ULC and Productivity growth (correlation)

(2000-2008)
Correlation Coefficient
ULC and Productivity
Commodity
Exports and Exports
Radio, TV and communications 0.47 -0.20
Medical 0.42 -0.36
Total Industry 0.29 0.33
Manufacturing 0.16 -0.35
Wearing Apparel -0.06 0.10
Publishing, printing etc -0.12 -0.06
Machinery and Eqp. -0.13 0.07
Chemicals -0.24 0.31
Wood and wood products -0.30 0.15
Food products and Beverages -0.50 0.62
Textiles -0.55 0.51
Other Transport Eqp. -0.58 0.62
Electrical machinery -0.64 -0.73
Source: Vienna Institute for International Economic Studies;
and IMF staff calculations

23. Croatia made limited headway in boosting its market share of specific export
items. This finding is broadly consistent with what was observed at the aggregate level
(Table 3). Detailed examination of market share, relative to the group of countries in the
sample, suggests very minimal gains. In fact, the trends in market share at various points
(1999, 2003, and 2008) indicate that of the thirteen products considered, only in three
instances was the market share in 2008 higher than in 2000. Relatively significant
improvements was recorded in transport and equipment (4.5 percent gain) and to a lesser
extent communications and equipment. However market share was lost in chemical products
(3 percent), apparel (2 percent) and medical instruments (0.5) percent.
 47

Table 3. Market Share

(Exports of Eastern Europe to the European Union) 1/
In percent
1999 2003 2007 2008
Manufacturing 3.04 2.31 1.75 1.68
Total industry 3.03 2.28 1.77 1.70
Food products 3.34 3.99 2.37 1.98
Machinery and equip. 2.6 1.7 1.9 1.9
Transport equip. 1.3 3.7 4.2 5.9
Wood products 5.61 4.36 4.11 4.07
Textiles 6.56 5.09 4.53 4.95
Apparel 5.85 3.94 3.21 3.06
Chemical products 6.4 3.9 2.7 2.6
High end products
Electrical machinery 2.12 1.32 1.09 1.14
Medical instruments 2.72 1.37 1.24 1.10
Office machinery 0.11 0.18 0.22 0.16
Communication equip. 0.15 1.99 1.02 0.87
Publishing and printing 3.33 2.00 1.26 1.31
1/ Eastern Europe includes Bulgaria, Croatia, Czech Rep., Estonia, Hungary, Latvia,
Lithuania, Poland, Romania, Slovak Rep., Slovenia, and Ukraine.
Source: Vienna Institute for International Economic Studies; and IMF staff calculations

24. The continued poor performance of Croatias export cannot be clearly linked to
developments regarding changes in cost and productivity. Croatia made limited strides in
increasing its presence in key markets and actually lost market share in major export
products. Interestingly, average ULC growth for many export goods and the manufacturing
sector was comparatively low, even though productivity growth in a wide range of
commodities was below average wage growth. These findings raise some interesting
questions relating to Croatias poor export performance. One clear outcome is that lower than
average increases in wage cost appear to have minimal impact on export performance in the
short run. This suggest that for Croatia to improve export performance it needs to record
wage declines and or productivity increases which far exceeds that of competitor countries.

25. High wages in Croatia partly reflects the legacy of pre transition period. The
overall increase in wage growth over the past decade is broadly in line with that of regional
peers. This point is highlighted by looking at wage differentials on an annual basis from
20002008. This analysis suggests that Croatias wages was above the average wage for the
region at the start of the period under consideration and was significantly higher than that of
the lower wage countries. The wage gap between Croatia and its regional peers have been
reduced over the years, which suggest that wage growth has not been particularly rapid, and
the wage competitiveness gap reflects some degree of inertia.
 48

12
Relative Monthly Wages
(Ratio HRV/Sample, 2001-2011)
10

Sample High (SLV)

8 Sample Low (UKR)
Sample Avg
6

Source: WEO, IMF Staff Estimates. Sample includes CESEE countries.

F. Conclusion

The result of this analysis suggests that Croatias high wage level is a major drag on
export performance. Disaggregated analysis of export products, suggest that wage growth
has been broadly in line with productivity and alludes to the historically high level of wages
as key constraint on price competitiveness. High wage level, together with weak business
environment, appears to have limited export performance. This implies that the policy
priority of the authorities should be on measures to contain or reduce the level of wages
along with structural measures to improve business environment and labor market flexibility.
This would result in an improvement in competitiveness, that would contribute towards
reducing the external financing requirement. Despite the recent improvements in the current
account deficit, financing requirements remains elevated and is projected to exceed
20 percent of GDP over the near term. Reducing the financing requirement and the
associated risk would be aided by an improvement in overall competitiveness. This would
boost exports, improve the external balance and increase the availability of domestic
resources to finance investment, which would also lead to a gradual reduction in the external
debt burden.
 49

Appendix

Figure 1: Market Share, 200011

220 220 200 200

Market Share (Croatian exports as a share of Market Share (Croatian exports as a share of
200 region's total imports, 2000=100) 200 180 region's total imports, 2000=100) 180
World
180 E.U. 180 160 160
Germany
160 U.S. 160 140 140

140 140 120 120

120 120 100 100

World
Emerging markets
100 100 80 Fuel exporting economies 80
Advanced economies
80 80 60 60

0.20 0.20 0.15 0.15

Market Share (Croatian exports in percent of Market Share (Croatian exports iin percent of
region's total imports) region's total imports)
0.12 0.12
0.15 0.15

0.09 0.09
0.10 0.10
0.06 0.06
World
0.05 E.U. 0.05 World
0.03 Emerging markets 0.03
Germany
Fuel exporting economies
U.S. Advanced economies
0.00 0.00 0.00 0.00

80 80 90 90
Market Share (Exports in percent of total) Market Share (Croatian exports iin percent of
region's total imports)

60 60
60 60
Emerging markets
E.U. Fuel exporting economies
40 40
Germany Advanced economies
U.S. 30 30
20 20

0 0 0 0

Source: IMF, Direction of Trad e Statistics and IMF staff calculations.

 50

Figure 2: Eastern Europe: Export and ULC, 200008

(Percent)
25 25 16 16
Manufacturing Manufacturing
14 14
Exports Wages
20 20
12 12
Unit labor cost Productivity

15 15 10 10

8 8
10 10 6 6

4 4
5 5
2 2

0 0 0 0
CZE
ROM

CZE

ROM
HUN

BGR
POL

BGR
POL

HUN
LVA

LVA
HRV

RUS

HRV

RUS
SVN

SVN
LTU

LTU
UKR

UKR
SVK

SVK
EST

EST
25 16
Industry Industry
14
20 Wages
Exports ULC
12
Productivity

15 10

8
10
6

4
5
2

0 0
ROM
CZE

POL
HUN

BGR
LVA
HRV

RUS
SVN

LTU
UKR

SVK
EST

ROM
CZE
POL

BGR

HUN

LVA
HRV

RUS
SVN

LTU
SVK

UKR
30 30 10 EST 10
Food Products Food Products
Exports
25 25
Unit labor cost 8 Wages 8
Productivity
20 20
6 6
15 15

4 4
10 10

5 5 2 2

0 0 0 0
HUN HRV EST ROM POL SVK LVA SVN LTU SVN HRV POL SVK HUN LTU LVA ROM EST

Sources: Vienna Institute for International Economic Studies; and IMF staff calculations.
 51

Figure 3. Eastern Europe: Export and ULC, 200008

(Percent)
30 30 18 18
Exports Machinery Equipment Machinery Equipment
16 16
25 Unit labor cost 25 Wages
14 14
Productivity
20 20
12 12
15 15 10 10

10 10 8 8

6 6
5 5
4 4
0 0
2 2

-5 -5 0 0
HRV HUN EST POL LTU LVA ROM POL HUN HRV LTU ROM EST LVA

35 35 16 16
Electrical Machinery Electrical Machinery
30 Exports 30 14 Wages 14

12 Productivity 12
25 Unit labor cost 25
10 10
20 20
8 8
15 15
6 6
10 10
4 4
5 5
2 2
0 0 0 0

-5 -5 -2 -2
HRV SVN HUN LTU POL SVK LVA EST ROM SVK POL SVN HUN HRV EST ROM LTU LVA

60 60 18 18
Transport Equipment Transport Equipment
16 16
50 Exports 50 Wages
14 14
Unit labor cost Productivity
40 40 12 12

10 10
30 30
8 8

20 20 6 6

4 4
10 10
2 2

0 0 0 0
POL ROM HUN SVN SVK EST LTU LVA HRV POL HUN SVN HRV SVK LTU EST ROM LVA

Sources: Vienna Institute for International Economic Studies; and IMF staff calculations.
 52

Figure 4: Eastern Europe: Export and ULC, 200008

(Percent)

14 14 14 14
Wood Products Wood Products
12 12 12 Wages 12
Exports
Productivity
10 Unit labor cost 10 10 10

8 8 8 8

6 6 6 6

4 4 4 4

2 2 2 2

0 0 0 0
HUN LTU POL EST HRV ROM LVA SVK POL HRV SVN HUN LTU EST ROM LVA

20 20 14 14
Textiles Textiles
Exports 12 Wages 12
15 15
Unit labor cost Productivity
10 10

10 10 8 8

6 6
5 5
4 4

0 0 2 2

0 0
-5 -5
LTU POL HUN LVA HRV ROM EST -2 -2
POL SVK SVN HRV HUN LTU LVA EST ROM

20 8
Apparel Apparel
15 6
Exports ULC

10 4

5 2

0 0

-5 -2 Wages
Productivity

-10 -4
HRV

LTU

ROM
SVK
ROM

POL

HUN
POL

EST
HUN

LVA
LVA
HRV

SVN
SVN

LTU

SVK
EST

Sources: Vienna Institute for International Economic Studies; and IMF staff calculations.
 53

Figure 5. Eastern Europe: Export and ULC, 200008

(Percent)
30 30 20 20
Chemical Products Chemical Products

25 Exports 25 Wages
Unit labor cost 15 Productivity 15
20 20

15 15 10 10

10 10
5 5
5 5

0 0 0 0
HRV HUN EST POL LVA ROM LTU POL HRV SVK SVN HUN LTU ROM EST LVA

50 50 25 25
Medical Instruments Medical Instruments
Exports Wages
40 40
20 Productivity 20
Unit labor cost

30 30
15 15

20 20

10 10
10 10

5 5
0 0

-10 -10 0 0
SVN HRV EST POL LTU SVK ROM HUN HRV SVN POL SVK HUN ROM LTU EST

Sources: Vienna Institute for International Economic Studies; and IMF staff calculations.
 54

Figure 6. Eastern Europe: Export and ULC, 200008

(Percent)
60 60 140 140
Office Machinery Office Machinery
Exports
50 50 120 120
Unit labor cost Wages
100 Productivity 100
40 40
80 80
30 30
60 60
20 20
40 40
10 10
20 20

0 0 0 0

-10 -10 -20 -20

HUN SVK LTU HRV SVN POL ROM POL SVK HUN SVN LTU HRV ROM

60 60 30 30
Communication Equipment Communication Equipmen t
50 Exports 50 25 Wages 25
Unit labor cost Productivity
40 40 20 20

30 30 15 15

20 20 10 10

10 10 5 5

0 0 0 0

-10 -10 -5 -5
ROM LTU EST SVN HUN POL HRV LVA SVK SVK POL SVN HRV HUN LTU EST ROM LVA

60 60 10 10
Publishing and Printing Publishing and Printing
50 50 8 8
Exports

40 Unit labor cost 40 6 6

30 30 4 4

20 20 2 2

10 10 0 0

0 0 -2 Wages -2
Productivity
-10 -10 -4 -4
LVA HRV SVN HUN SVK LTU EST POL ROM SVK SVN POL HRV LTU LVA HUN EST ROM

Sources: Vienna Institute for International Economic Studies; and IMF staff calculations.