ZAGREB, February 27, 2020 - After five years of economic recovery, Croatia's GDP in 2019 reached the pre-crisis level but compared to the European average, Croatia did not converge from 2008 to 2018, reads a report the European Commission published on Wednesday.

The report also notes that Croatia has continued making progress in correcting macroeconomic imbalances but that they are still present.

As part of its European Semester Winter package, the EC published reports on the overall economic and social progress in each member state and an analysis of the macroeconomic situation in the countries with macroeconomic imbalances or excessive macroeconomic imbalances.

The report on Croatia has 79 pages, including annexes.

The EC notes that a stable economic growth in the last five years, combined with a careful macrofiscal stabilisation policy has made it possible for the country to gradually reduce the high levels of public, private and foreign debt, which in turn has reduced the economy's vulnerability.

The unemployment rate has continued to fall, thereby raising the disposable income of households. However, in 2018, Croatia’s GDP per capita relative to the EU average was still at the same level as ten years earlier, meaning that there was no convergence at all.

GDP per capita, measured by the purchasing power, in 2018 was 63% of the European average, the same as in the pre-crisis 2008. Moreover, Croatia has fallen behind even more in relation to more advanced comparable countries of Central and Eastern Europe, which have left it behind. Despite a stable growth, a relatively low growth potential will continue to be an obstacle to catching up with other EU countries.

Participation in the labour market and labour productivity remain low, and the business environment and the public administration are insufficiently supportive of faster economic convergence. Implementation of policy measures addressing these weaknesses is proceeding at an uneven pace.

"Addressing structural weaknesses with lasting effect would enable Croatia to converge faster to the rest of the EU," the EC stresses.

Croatia has made limited progress in addressing the 2019 country-specific recommendations and, just as in 2019, it has macroeconomic balances. In 2019 Croatia left the category of countries with excessive macroeconomic imbalances to enter the category of countries with macroeconomic imbalances.

Since the start of the European Semester in 2014, 57% of all country-specific recommendations addressed to Croatia have recorded at least 'some progress'. 'Limited' or 'no progress' has been made in the remaining 43% of the recommendations.

Implementation of the reform agenda has proceeded at an uneven pace in different policy areas.

Most progress has been made on fiscal policy and labour market. There has been some backtracking on pensions after elements of the reform designed to increase the statutory retirement age were suspended as demanded by trade unions, the EC says.

In 2019 Croatia saw limited progress in the implementation of the EC recommendations.

Certain progress was recorded in the implementation of the curricular reform and the management of state agencies.

Certain progress was made with the adoption of a new set of active employment measures.

In 2019 agreements on some key rail transport projects were signed, which contributed to progress on sustainable transport.

Certain progress has been made in court proceedings by expanding electronic communication in courts and reducing backlogs.

As regards the business environment, improvement has been achieved by introducing a number of measures designed to reduce administrative obligations and liberalising services.

Progress has been limited in other areas, such as reinforcing the budgetary framework, improving the social protection system, reforming wage setting frameworks, improving corporate governance and intensifying the divestment of shares and stakes in state-owned enterprises, and in the prevention and sanctioning of corruption.

Macroeconomic imbalances

Croatia has been making progress on macroeconomic indicators but it still has macroeconomic imbalances. In 2019 it exited the category of excessive macroeconomic imbalances.

Public debt remains high, but is falling rapidly. Public finances have improved and Croatia recorded its first fiscal surplus in 2017, and its second in 2018, despite a non-negligible materialisation of contingent liabilities.

Thanks partially to improvements in public debt management, debt is being refinanced at record low and predominantly fixed rates, with extended maturities.

The improvements in public finances were recognised by Fitch and S&P agencies as they upgraded Croatia's long-term sovereign credit rating to investment grade.

Improvements have been recorded also in household debt.

The consolidated corporate and household debt levels for the third quarter of 2019 are estimated at 58.4% and 34.3% of GDP respectively, some 24 and 8 percentage points below the peak registered in 2010.

Although the current account surplus is shrinking, it is still helping to curb external imbalances.

After peaking at 3.3% of GDP in 2017, the current account surplus narrowed to 1.9% of GDP in 2018, as the increase in imports of goods turned the trade balance negative.

The current account surplus rebounded in the first three quarters of 2019 to 2.2% of GDP largely due to growing tourist receipts.

Low potential growth remains an obstacle to Croatia catching up with the rest of the EU more rapidly, says the EC.

After reaching a low point in 2010, potential output growth has since increased significantly, estimated at 2.1% in 2019. Although this is higher than the EU average, it is the lowest among peer countries.

The labour contribution to potential growth turned positive in 2019, due to a gradual recovery of employment, though it remains one of the lowest among peers. Demographic trends and a chronically low activity rate are a drag on labour contribution to growth for future years.

"Significant structural reforms will be necessary to increase Croatia's relatively low potential growth," the EC notes.

Potential growth is projected to remain the lowest among Croatia's peers throughout the 2019-2021 period.

Despite improvements in the labour market, increasing the labour contribution to potential growth will require raising the low activity rate, which will be difficult, notably because of the demographic challenges in the country.

Productivity growth is still limited due to poor allocative efficiency, complex business environment and public sector inefficiency, the EC says.

As for tax policy, the EC says that Croatia’s taxation system is strongly skewed towards indirect taxation and is Croatia is among the member states which collect the least revenue from direct taxes.

This is partly a consequence of very low property taxes, which are considered to be among the most growth-friendly taxes.

The low share of direct taxation is also a reflection of successive cuts in the personal income tax implemented over the past four years.

Aimed at reducing the tax burden on labour, the cuts have resulted in more than half of persons in employment not being liable for any personal income tax.

Still, Croatia ranks around the EU average when it comes to revenue from social contributions in proportion to GDP, despite having the third lowest employment rate in the EU.

At the same time, Croatia collects the highest share of VAT revenue in proportion to GDP of all EU member states.

In cooperation with Croatia, the EC has prepared a special annex on the health system, which says that despite the strong increase in revenue from health contributions, the healthcare sector continues to accumulate arrears.

The revenue of the Croatian Health Insurance Fund (CHIF) is estimated to have increased by 11% (year-on-year) in 2019. In spite of this, payment arrears to suppliers of goods and services are estimated to have grown by over 15%. Furthermore, expenditure is expected to grow strongly in 2020 on the back of wage increases in the sector agreed in September 2019 and the Supreme Court ruling from December 2019 which upheld doctors' claims on unpaid overtime.

Arrears are mostly generated in hospitals, particularly those owned by counties.

Faced with the prospect of suppliers suspending deliveries, the central government settles such arrears through ad hoc financial recovery programmes. There have been 12 such interventions since 2000, ranging from 0.1 to 0.6 per cent of GDP in a given year, the EC says.

With regard to the fight against corruption and organised crime, the EC says that control and sanction mechanisms are weak, notably at local level.

Although there is a considerable number of investigations and indictments in cases related to organised crime and corruption, the inefficiencies of the justice system, such as lengthy court proceedings, often impede closure. Official statistics also show that a significant proportion of corruption offences are recorded at local level.

The Law on Local and Regional Self-Governance, which gives elected local officials considerable discretion in decision-making without subjecting them to asset declarations or other forms of oversight, remains a concern.

The discretionary powers to decide on disposing of assets and finances of up to HRK 1 million and to appoint board members of public local companies create scope for corruption, the EC says.

With regard to environmental sustainability, the EC notes that there is still a long way to go in the transition from a linear to a circular economy in Croatia. Besides some isolated initiatives, Croatia has no comprehensive circular economy strategy, it says.

Despite some progress, shifting waste from landfilling towards recycling remains a priority.

In Croatia, 25% of municipal waste was recycled in 2018 - a big improvement from 4% in 2010, but still substantially below the EU average of 47%. Landfilling of municipal waste remains high at 66% (EU average 22%).

A continued strong effort would help Croatia to converge to the EU average and ultimately contribute to achieving the European target of zero pollution, the EC says.

The EC also notes that air pollution has a significant impact on people's health, that sewage systems are underdeveloped and that the water supply networks face high leakage rates.

As for greenhouse gas emissions, Croatia will have no problem meeting the EU targets for the period until 2020 but it will need additional measures to meet the targets set for the period until 2030.

The share of renewable energy sources is 28%, but in traffic it is very low, standing at a mere 3.9% in 2018, one of the lowest rates in the EU, the EC says.

More news about Croatian economy can be found in the Business section.