Fiscal Austerity in Croatia

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Fiscal Austerity in Croatia INTERNATIONAL POLICY ANALYSIS No More Buying Time: Fiscal Austerity in Croatia VELIMIR ŠONJE September 2012 n In the initial phase of the crisis (2008–2010) the HDZ-led centre-right government allowed a wider fiscal deficit and strong growth in public debt, although they cut public infrastructure programmes and introduced new taxes. The idea was to buy time in order not to cut public sector wages, subsidies and transfers. This fiscal strat- egy proved to be wrong as GDP recorded one of the sharpest contractions in Europe in this period. n The new SDP-led centre-left government that took office in January 2012 faced two real threats: exploding public debt and a deterioration in credit ratings. In order to cope with these threats, the new government initiated stronger fiscal adjustment on the expenditure side. n The »austerity vs. growth« debate does not seem to be a good intellectual frame- work for thinking about policies in the case of Croatia, as postponing austerity re- quires finding someone to finance the deficit at low interest rates. That may be impossible for the time being, so some degree of austerity seems to be a necessity in Croatia. VELIMIR ŠONJE | NO MORE BUYING TIME: FISCAL AUSTERITY IN CROATIA Introduction est rates, postponement of fiscal adjustment may lead to a vicious circle of ever growing interest rates. It is easy to find reasons for postponing fiscal austerity. One may fear the weakening of the welfare state. One In countries with such characteristics, governments may argue that fiscal multipliers in a recession are high, have to show fiscal prudence earlier than in the most so spending cuts may deepen the recession (IMF 2012). developed countries. The coalition led by the Social Another line of argument against austerity is fear of Democrats (SDP), which came to power in January 2012, strong political resistance to fiscal cuts: resistance may was aware of this fact. It initiated a fiscal adjustment undermine social cohesion and lead to a sharp social programme immediately after the elections in December conflicts with political consequences that are hard to 2011. The main motivation was to avoid a credit rating predict. A mixture of these arguments explains why the downgrade due to fears of an additional increase in the centre-right coalition led by the Croatian Democratic cost of financing for the government and the economy Union (HDZ), which was in power from 2004 to 2011, as a whole. postponed stronger fiscal adjustment despite prolonged recession and crisis. HDZ’s fiscal strategy was to It is not fair to say that the centre-right HDZ-led government implement the minimum necessary adjustment and to did nothing while the SDP-led government did everything buy time. They thought that a somewhat expansionary needed for fiscal adjustment. We shall go into more detail fiscal policy would alleviate the recession and hoped about early centre-right experiments with higher taxes that some (positive) external shock would push GDP and cuts in public infrastructure investment in 2009. After and public revenues higher, providing a magic cure for all, the centre-right government passed the Law on Fiscal otherwise serious fiscal problems. Responsibility which rounded off the framework for fiscal discipline. The same legal framework is used by the Social This view turned out to be overly optimistic. The recession Democrats, too. HDZ also managed to start reducing the was particularly strong and prolonged compared to public expenditure to GDP ratio in the second stage of the other European countries, possibly due to late fiscal crisis (2010–2011). However, the centre-right government adjustment. had insufficient political power to initiate the expenditure cuts needed to bring public debt under control. Stronger Buying time in terms of postponement of fiscal adjust- fiscal cuts started only after the Social Democrats took ment is an option for countries such as the United States power and it still remains a puzzle whether these cuts will and Japan. Such countries print global currencies which be enough to stabilise the cost of financing and prevent are much in demand. Their governments enjoy access to a deterioration of the credit rating, which remains BBB–. large pools of diversified institutional investors who are eager to buy »safe haven« government bonds at times of general risk aversion. In contrast, small and open middle Macroeconomic Framework income countries such as Croatia stand at the opposite end of the financial spectrum. Their currencies are not The period 2002–2007 was marked by the overheating of widely used; even residents use foreign denominated the Croatian economy. It was reflected in strong capital deposits and securities for savings purposes while most inflows, accumulation of foreign debt, a widening current public debt is denominated in foreign currencies. Financial account deficit and continuous expansion of government wealth is thin and institutional investors underdeveloped. expenditures (Table 1). Resulting GDP growth (4.8 per Credit rating agencies take these facts about financial cent on average in the period 2002–2007) was relatively structure into account, so there is little room to manoeu- high, largely driven by investment in infrastructure and vre for the governments of such countries. Their ability to real estate (widely intermediated by the government). run fiscal deficits and accumulate public debt is limited. Investments in technology and processes that might lead It is not possible to understand the austerity vs. growth to lasting increases in productivity were lacking. The dilemma if these basic facts about financial structure are absence of investment leading to lasting enhancements not taken into account. When there is nobody out there in productivity and competitiveness implied that pre- willing to finance higher fiscal deficit at reasonable inter- crisis economic growth was largely demand and debt 1 VELIMIR ŠONJE | NO MORE BUYING TIME: FISCAL AUSTERITY IN CROATIA Main macroeconomic indicators 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 GDP per capita (Euros) 6,349 6,816 7,436 8,112 8,951 9,781 10,722 10,111 10,394 10,472 Real GDP growth (%) 4.9 5.4 4.1 4.3 4.9 5.1 2.1 -6.9 -1.2 0.0 Real GDP index 100 105.4 109.7 114.4 120.0 126.2 128.8 119.9 118.5 118.5 Real average net wage index 100 103.7 107.7 109.3 111.4 114.0 115.0 115.2 114.9 114.6 CPI inflation rate (avg) 1.7 1.8 2.1 3.3 3.2 2.9 6.1 2.4 1.1 2.3 Unemployment rate (%) 14.8 14.3 13.8 12.7 11.2 9.6 8.4 9.1 11.8 13.5 BOP C/A (% of GDP) -7.2 -6.0 -4.1 -5.3 -6.6 -7.2 -8.8 -5.2 -1.0 -1.0 Foreign debt (% of GDP) 53.7 65.7 69.5 72.1 74.8 77.7 85.4 101.0 101.2 99.6 HRK vs EUR (end of year) 7.4 4 7.65 7.67 7.38 7.35 7.33 7.32 7.31 7.39 7.53 General gvt fiscal balance (% of GDP) -4.3 -5.4 -4.2 -3.5 -3.4 -3.0 -2.1 -4.6 -5.3 -5.3 Public debt (% of GDP) 34.8 35.4 37.6 38.2 35.4 32.9 29.3 35.8 41.3 45.7 with guarantees and HBOR n.a. n.a. 44.8 45.3 45.8 43.5 41.9 50.5 58.7 62.5 General gvt expenditures (% of GDP) 42.7 42.7 42.7 40.8 40.6 41.2 41.2 42.5 41.6 40.7 Source: www.hnb.hr, Publications. Author’s own calculations. www.mfin.hr for public debt figures. driven. The hard landing that came after the crisis in the economy was contracting at a high rate (final real GDP aftermath of the Lehman Brothers collapse did not come for 2009 was –6.9 per cent). Expenditure stimulus was as a surprise. insufficient to prevent decline: public revenues were declining sharply, leading to a strong increase in the fiscal Economic activity slowed down in 2008 and a recession deficit, from 2.1 per cent of GDP in 2008 to 4.6 per cent started in late 2008/early 2009. Croatia has not seen of GDP in 2009 and 5.3 per cent in 2010 and 2011. The a single year of GDP growth since then. Additional cost of government financing followed a similar path: contraction of GDP (between 1 and 2 per cent) and long-term government bond yields hovered between 6 significant growth in unemployment are expected in per cent and 7 per cent per annum. 2012. It is likely that real GDP as of the end of 2012 will remain approximately at the 2005–2006 level (see real A political crisis erupted in 2009 in parallel with the GDP index in Table 1). Average real wages shall perform economic one. Former Prime Minister Ivo Sanader somewhat better, converging to the 2008 level (Table 1). resigned and Prime Minister Jadranka Kosor (also HDZ) The government initially reacted by postponing fiscal took office in mid-2009. Prime Minister Kosor focused adjustment and the fiscal deficit went up. There was a on completing the EU accession negotiations (which she widespread belief that recession might be avoided, partly did successfully in spring 2011). The second priority was by using fiscal stimuli. Despite a significant slowdown intra-party political battles, as corruption charges against of economic activity in 2008, general government former Prime Minister Sanader and a number of his (and expenditures rose 7.8 per cent.
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