IMF Wraps Up 2023 Article IV Consultation with Croatia

Executive Board Assessment

The euro adoption marks a momentous milestone for Croatia and is a testament to diligent policymaking and concerted efforts. The economy has also proven resilient in the face of the pandemic and the war in Ukraine and recorded another year of strong growth in 2022. However, surging global energy and food prices pushed headline inflation to a multi-decade high towards year end. While inflation has peaked, it remains elevated and broad-based. The 2022 external position was broadly in line with the level implied by fundamentals and desirable policies.

Growth is set to moderate in 2023. Weak external demand, tightening financial conditions, and still elevated global uncertainty would weigh on growth, partially offset by a decline in global commodity prices, resilient tourism, and a buoyant labor market. Higher growth is anticipated from 2024, underpinned by a recovery in the global economy and reforms under the NRRP. Inflation is expected to be sticky, averaging about 7½ percent in 2023, and to gradually fall towards the ECB's target of 2 percent by late 2025. The outlook remains subject to significant uncertainty.

The near-term fiscal policy needs to complement monetary tightening and avoid adding to aggregate demand. The labor market is tight, core inflation remains elevated, and the euro adoption has mitigated the impact of ECB's tightening. Therefore, an expansionary fiscal stance risks fueling domestic demand and inflation and hurting Croatia's competitiveness. Broad-based support measures—notably energy price caps and tax cuts—need to be reversed.

Maintaining a growth-friendly fiscal consolidation over the medium-term is paramount, by improving tax policy, reducing spending rigidity, and enhancing spending efficiency. Given Croatia's high budget spending rigidity and the need to further reduce public debt, any tax reforms should preserve revenue resources while improving the tax system structure to reduce distortions and support fairness and growth. Modernizing the property tax and reducing favorable taxation on short-term rental income would help dampen housing demand, boost supply, and encourage labor participation. A simplified and transparent public sector pay system that rewards merit and productivity would enhance public services and make the sector more efficient. Worsening healthcare and pension costs due to an aging population call for renewed efforts to lengthen the working life and decisively address healthcare arrears. In addition, enhancing the monitoring and corporate governance of SOEs will reduce potential fiscal risks and maximize their contribution to growth. Efforts to strengthen the public investment management system, including establishing a strong central coordination function in the MOF, should continue.

The financial system is currently stable; continued vigilance is needed given ongoing challenges. The banking system has remained profitable, well-capitalized, and extremely liquid. Although household and corporate vulnerabilities have moderated since the pandemic, a deeper economic slowdown amidst higher interest rates could pose new challenges. In addition to the announced increases of the counter-cyclical capital buffer, explicit borrower-based measures could be considered to contain potential future financial stability risks of housing market pressures, taking into consideration measures already in place and other risk mitigating factors. A comprehensive review of housing support measures should be considered to address the housing affordability challenge.

Advancing structural reforms is key to reap the full benefits of euro adoption and sustaining income convergence. The authorities should continue their commendable and steadfast implementation of the NRRP. Raising productivity, advancing the green and digital transition, and making the best of an aging and declining population are priorities. The currently tight labor market offers an opportunity to carry out further labor market reforms. More ambitious reforms, along with the EU funds, are warranted to address relatively low firm-level productivity and inefficient resource allocation. A comprehensive climate strategy, beyond the NRRP and fully aligned with the energy strategy, will help diversify the energy mix, promote energy savings, improve energy efficiency, and accelerate the green transition. In particular, an economy-wide carbon pricing accompanied by sectoral policies and targeted support to the vulnerable can help promote cost-effective emissions reductions and ensure adherence to the EU-wide targets.