RePort No. 17261-HR Croatia Beyond Stabilization

December 19,1997 Public Disclosure Authorized EuroPe and Central Asla Poverty Reぐ―uct 旧n and Econom に Managenlent

@ Public Disclosure Authorized Public Disclosure Authorized

Document of the World Baak

網田国国目国日国国国国園園 国日園 Public Disclosure Authorized List of Acronyms and Abbreviations

BRA Bank Rehabilitation Agency CBS Central Bureau of Statistics CEE Central Europe Economies CIT Corporate Income Tax CMEA Council for Mutual Economic, Assistance CPF Croatian Privatization Fund CPI Consumer Price Index DFI Direct Foreign Investment FSRY Former Socialist Republic of'Yugoslavia FY Fiscal year GDP Gross Domestic Product HEP Croatian Electricity Co. HII Health Insurance Institute HPT Croatian Post and Telecommunications HZ Croatian Railways Ltd. INA Industry of Oil Co. LRSE Law on the Restructuring of Selected Enterprises NBC National Bank of Croatia OECD Organization for Economic Cooperation and Development ORESE Office for the Restructuring of State Enterprises PAYGO Pay as you go (pension system) PBZ Privredna.Banka Zagreb PIT Personal Income Tax SEC Securities and Exchange Commission SIMAF State Institute for Macroeconomic Analysis and Forecasting SFRY Socialist Federal Republic of Yugoslavia UCEA Unified Classification of Economic Activities ULC Unit Labor Cost VAT Value Added Tax

Currency Unit Croatian Kuna (HRK)

Average Exchange Rates (Kuna per US$)

1992 1993 1994 1995 11996 0.264 3.58 5.99 5.23 5.43

Fiscal Year January 1 - December 31

Vice President: Johannes Linn, ECA Country Director: Arntraud Hartmann, ECC02 Sector Director: Pradeep Mitra, ECSPE Responsible Staff. Jean-Jacques Dethier (Task Team Leader), Marcelo Bisgono (ECSPE), Gerardo Corrochano, Madalene O'Donnell (ECC02) TABLE OF CONTENTS

EXECUTIVE SUMM ARY ...... vii CHAPTER ONE FROM HYPERINFLATION TO GROW TH ...... I A Particular Transition Economy...... 2 From Hyperinflation to Stabiliaziattio ...... 4 mergingMacroeconomic Disequilibria ...... 5 The Deterioration of National Savings...... 7 The Sources of the Emerging Disequilibria...... 10 S uppl' S id e ssues ...... I I P u b lic F inance Isu es ...... 14 From Stablization to Growth - The Medium-term Policy Agenda...... 15 M icroeconomic Reforms...... 6 Public Finance Reform ...... 17

PART ONE CHANGING IN CENTIVES ...... 9

CHAPTER TWO HOW TO FOSTER THE SUPPLY RESPONSE? ...... 21 G overnance Issues ...... 23 Privatized Enterprises...... 24 State E nterprises ...... 25 The Incentive System: Price and Trade Distortions...... 28 Soft Budget Constraints...... 29 Legal and Institutional Framework...... 29 Government Bail-outs...... 30 Bank-Enterprise Nexus...... 31 Supply Response Strategy...... 31 CHAPTER THREE HOW TO IMPROVE FINANCIAL DISCIPLINE AND GOVERNANCE IN THE ENTERPRISE SECTOR?...... 33 Section I - Resolving the Enterprise Crisis...... 33 Downsizing and Restructuring State Enterprises...... 33 Social Safety Net...... 35

This report is based on the findings of various economic missions that visited Croatia in 1996 The main mission took place between January 30 - February 9, 1996. was led by Olivier Godron, and included Gerardo Corrochano, Yves Du%i% ier. David Lindeman, Nena Manley. Jorge Martinez, Sandor Sipos, and Laszlo Urban The report was prepared by Oli% ier Godron, with main contributions provided by Marcelo Bisogno, Yves Duvivier, Merlinda Ingco, Severin Kodderitzsch, Da id Lindeman, Jorge Martinez. Sandor Sipos, and Juan Zalduendo. Reseanch assistance was provided by Kaniz Siddique The Peer Re% ie.ers were K3 le Peters and Martha de Melo. The Country Director was Arntraud Hartmann. The authors mould like to acknowledge the exceptional support provided by the Croatian authorities during the preparnion of this report, while taking full responsibility for its contents. I The report was processed by Dorota Kowalska and Armanda Carcani. 11

Section 2 - Trade Liberalization...... 36 Section 3 - Com pleting the Privatization Agenda...... 37 Voucher Privatization...... 37 Prom oting Indirect Shareholding...... M atching Supply and Dem and ...... 39 Shareholder's Awareness...... 40 'M apping' Privatization...... 40 Public Enterprises and Large Entities...... 40 Telecom m unications...... 41 Electricity...... 42 Privatization in the Agriculture Sector...... 42 Privatizing A grokom binats...... 43 Land M arkers...... 43 CHAPTER FOUR HOW TO STRENGTHEN FINANCIAL INTERMEDIATION?...... 45 Section 1 - Strengthening Bank Interm ediation...... 45 The Banking System Crisis...... 45 Beyond the Short-term Crisis: Structural W eaknesses...... 46 A Constraint to Lower Interest Rates: Low Bank Profitability...... 47 The Slow Em ergence of New Players ...... 49 Issues w ith Bank Ownership and Governance ...... 49 Policies for the Banking System ...... 51 Restructuring and Privatizing Troubled Banks...... 51 Alleviating Financial Repression...... 52 Deposit Insurance, Regulation and Supervision...... 52 Secured Lending ...... 53 Section 2 - Capital M arkets...... 54 Recent Developm ents...... 54 Developing Capital M arkets...... 56 Building a Conducive Environm ent...... 56 Stim ulating the Supply of, and the Dem and for, Financial A ssets...... 57

PART TWO TOWARDS A MORE GROWTH-FRIENDLY PUBLIC SECTOR...... 59

CHAPTER FIVE A MEDIUM-TERM STRATEGY FOR PUBLIC FINANCE ...... 61 W hy is Croatia's Public Sector so Large?...... 62 Is a Crisis Threatening?...... 63 A Public Finance Strategy...... 64 W hat are the M ain Com ponents of the First Phase? ...... 65 How are these Additional Costs Financed?...... 65 Are there any Risks to the Effective Implementation of this First Phase?...... 66 What is the Key Goal of the Second Phase of the Strategy for Public Finances?...... 67 iii

CHAPTER SIX HOW TO CONTAIN PUBLIC CONSUMPTION AND TRANSFERS?...... 69 Section 1 - Civil Service Reform ...... 69 Im proving Productivity in the Public Sector...... 70 Incentives in the Civil Service...... 70 Section 2 - Reform ing the Health Sector ...... 71 M ore Cost-effective Spending ...... 72 Better Cost-control M echanism s...... 73 Budget Approval and Control...... 74 Budgeting Mechanism s...... 74 The Dem and Side...... 76 Privatization in the Health Sector...... 76 Section 3 - Reform ing the Pension System ...... 77 Reform ing the Pay-as-you-go System ...... 78 M oving to a M ulti-Pillar System...... 8 Designing a Two-pillar System ...... 80 How to Finance the Initial Transition Costs?...... 82 CHAPTER SEVEN H O W TO REFORM TH E TAX SYSTEM ?...... 87 Section 1 - R ecent Developm ents and Revenue Perform ance...... 87 Section 2 - Directions for Tax Reform ...... 90 Introducing the VAT ...... 90 Reducing Labor Taxation...... 91 Bringing Capital in the Tax Net...... 92 Shifting Payroll Taxes to General Taxation...... 93 Other Tax Measures ...... 93 Strengthening Tax Adm inistration...... 95 Organization...... 95 Collections...... 97 Audit and Control ...... 97 Personnel and Training...... 98 Legal Issues ...... 98

STATISTICAL APPENDIX ...... 101 iv

List of Graphs

Chapter I 1.1 Gross Social Product and Investm ent (1953-94)...... 8 1.2 Output, Em ploym ent and Productivity in the Industrial Sector...... 8 1.3 Productivity, Real W ages and Unit Labor Costs in the Industrial Sector...... 8 1.4 Inflation and Monetary Aggregates ...... 8 1.5 Evolution of Exchange Rates...... 8 1.6 Exports and Im ports (in Current Dollars)...... 8 1.7 Evolution of Output across Industrial Subsectors...... 13 1.8 Evolution of Exports by Industrial Subsectors...... 13 1.9 Enterprise Results by Ownership Structure (in % of GDP)...... 13 1.10 Enterprise Results by Ownership Structure (in Kunas per Capita)...... 13 Chapter II 2.1 Distribution of Sales...... 22 2.2 Distribution of Em ploym ent...... 22 2.3 1994 Pre-Tax Results...... 22 2.4 1995 Pre-Tax Results...... 22 2.5 Sales per Em ployee...... 22 2.6 Changes in Real Sales...... 22 Chapter IV 4.1 Return on Equity of Croatian Banks...... 5 4.2 Return on A ssets of Croatian Banks...... 50 4.3 'Leverage' of Equity in Croatian Banks...... 50 4.4 Distribution of the Banking System 's Assets...... 50 Chapter VI 6.1 GNP and Health Expenditure per Capita in Selected Transition Countries (1994)...... 72 6.2 M ain Com ponents of Health Expenditures...... 75 Chapter VII 7.1 Governm ent Expenditure and Revenue ...... 87

List of Boxes

Chapter I 1.1 Croatia at a Glance...... 1 1.2 Five Years for a 'N orm alization ...... 3 1.3 Unem ploym ent and Poverty...... 7 Chapter H 2.1 Croatia's Enterprise Sector ...... 21 2.2 The Transform ation Law ...... 23 V

Chapter III 3.1 The Bank Rehabilitation Legislation...... 33 3.2 IN A, A Restructuring Case Study...... 34 3.3 Croatia's Accession to the W TO ...... 37 Chapter IV 4.1 Croatia's Banking System ...... 46 4.2 Financial Repression...... 48 Chapter V 5.1 Reconstruction in Croatia...... 65 Chapter VI 6.1 The 1993 Reform s in the Health System ...... 71 6.2 Croatia's Pension System ...... 77 6.3 W hy Introduce a Second Pillar in Croatia's Pension System ...... 81 6.4 Technical Issues of Second Pillar Reform ...... 84 Chapter VII 7.1 Croatia's Tax System ...... 90 7.2 Options to Reduce Payroll Taxes...... 94 7.3 Tax Adm inistration and Financial Police...... 96

List of Tables

Chapter I 1.1 Croatia: M ain Econom ic Indicators...... 6 1.2 Savings-Investm ent Balances ...... 9 1.3 Three Financing Scenarios...... 11 1.4 A M edium -term Scenario...... 16 Chapter H 2.1 Selected Enterprise Indicators by Ownership Status (end-1995...... 26 2.2 Trends in the Labor M arket...... 27 Chapter III 3.1 Expenditure of the Unem ploym ent Fund...... 36 vi

Chapter IV 4.1 Main M onetary and Credit Aggregates...... 45 4.2 Key Banking System Indicators (1995) ...... 47 Chapter V 5.1 Government Expenditure and Revenue in Selected Transition Countries (in percent of GDP)...... 61 5.2 Public Expenditure (1991-96)...... 62 5.3 Dependency Indicators...... 63 5.4 A M edium-term Public Finance Scenario...... 66 Chapter VI 6.1 Government Employment and W age Bill in Selected Countries (1995)...... 69 6.2 Expenditure and Revenue of the Health Insurance Fund...... 73 6.3 Key Indicators of the Pension System ...... 79 Chapter VII 7.1 Central Government's Tax Revenues...... 88 7.2 Structure of the Tax System in Selected CEE Countries (1995)...... 89 7.3 The W edge between Labor Costs and Take-home Pay ...... 92 7.4 Two Options to Reduce the Level of Payroll Taxes...... 93 EXECUTIVE SUMMARY

Croatia's economic recovery has been highly praised and justifiably so given the adverse conditions surrounding its emergence as an independent state and the success of its stabilization program. Nonetheless, the pressing question -- and the basis of this report -- is whether the fundamentals of this recovery point to a period of sustained economic growth.

Croatia has overcome a hyperinflation process that reached monthly levels of 28 percent in late 1993 and, since then, has achieved an unprecedented degree of stability under the most adverse circumstances. As a result, Croatia now enjoys one of the lowest inflation rates in Europe, price stability has lasted for four years, and growth has resumed. The unquestionable success attained in the management of the crisis and of the ensuing stabilization effort has, however, not been matched by the performance of the real sector.

Immediately after declaring independence from the Socialist Federal Republic of Yugoslavia (SFRY) in 1991, Croatia was plunged into a conflict that seriously disrupted production and trade, inflicted severe physical destruction on infrastructure and housing, increased defense and defense-related expenditure and forced 600,000 people from their homes. GDP fell by a cumulative 30 percent between 1991 and 1993. Croatia's economic problems, however, pre-dated the conflict of the early 1990s. At the time of independence, Croatia was already in the midst of a recession that resulted in a fall of 11 percent in GDP between 1987 and 1990. The conflict seriously worsened the already difficult economic situation. In 1991 alone, GDP fell by 20 percent, the fiscal and current account position deteriorated into deficits equivalent to 5 percent of GDP and inflation accelerated. The country had, at the time, virtually no foreign reserves to confront the crisis since these were retained by the Yugoslav National Bank in Belgrade. On October 3, 1993 the Government launched what turned out to be one of the most successful stabilization programs in the region. Inflation, which had soared to average monthly levels of approximately 28 percent during the first ten months of the year, dropped to zero in November and was followed by a 3 percent deflation in 1994.

Four years have passed since the stabilization program was put in place. Since then, annual inflation rates have been below 4 percent, the fiscal accounts remain under control, foreign reserves have continued to grow and the country has experienced three consecutive years of growth. In the meantime, Croatia has begun to transform its economy by turning more than 50 percent of the economy into private hands and by taking the initial steps towards modifying ownership links between enterprises and banks --all while transforming its institutions from what was previously one state in a federation into an independent sovereign State. In addition, Croatia has regained control over virtually all its territory, and the return of Eastern Slavonia to Government control is in sight. The peace has improved long term prospccts, giving Croatia now the opportunity of eliminating all remaining obstacles to complete its transition to a modern market-oriented economy.

The accomplishments in terms of stabilization have, unfortunately, not been matched by improvements in the performance of the real sector. The recent evolution of GDP was largely a result of one-time improvements connected to reconstruction and tourism. In other sectors, the economy has not yet been able to enter a process of substantial output recovery. In fact, industrial output has remained relatively flat across sectors, pointing to a slow adjustment to new viii markets and incentives. Despite this disappointing performance, real wage increases have outpaced productivity gains in industry during the last three years. The strong recovery of real wages has fueled consumption and has contributed to a deterioration of both national savings and external accounts --undoubtedly one of the most pressing problems for Croatia.

This deterioration of national savings creates serious constraints for future growth particularly since the levels of investment necessary to restore the country's productive capacity, damaged by war and years of neglect under socialism, can be only partiallyfinanced through increased foreign investment and borrowing abroad. Ultimately, increasing investment will have to be achieved by increasing national savings. This report analyses these worrisome developments and concludes that, in order to improve investment and savings, decisive actions should be taken in two key areas: improving microeconomic efficiency and fiscal reforms.

This report finds, first, that structural reform in Croatia has achieved only partial improvements in allocative efficiency. Privatization, predicated on 'insider buyouts', may have actually had ambiguous effects on enterprise governance, and left the largest enterprises in State hands. These enterprises continue to operate under soft budget constraints, maintaining their access to either foreign borrowing or domestic bank financing. Troubled public enterprises were, in fact, often the shareholders of the largest banks and thus able to influence their lending decisions. Only since 1996 has this 'related party' phenomenon begun to be addressed through the reform of both the banking system and selected large public enterprises. Second, the size and structure of Croatian public finances have helped depress savings and dampen growth. War- related and social expenditures have not only propelled public expenditure to high levels -- almost 50 percent of GDP -- but have also crowded out investment programs and helped delay the full overhaul of the highly distortionary tax system.

In order to restore microeconomic efficiency, stimulate the supply response and regain appropriate levels of savings and investment, Croatia needs to enhance enterprise and bank governance and competition and transform its public sector.

Enhancing Enterprise and Bank Governance and Competition

* Government-lead Enterprise Restructuring. Croatia needs to address more forcefully the downsizing, or exit, of large loss-making enterprises. Given their losses --gross losses were equivalent to 10 percent of GDP in 1995 and 11 percent in 1996-- this alone would result in substantial gains in financial resources available for productive use. Important steps have been recently taken by shifting the ownership of troubled banks away from enterprises to the Bank Rehabilitation Agency (BRA). The BRA now needs to impose financial discipline on problem enterprises, and be an effective catalyst for their restructuring or force their exit from the marketplace. This action needs to be complemented, particularly in the agriculture sector, by trade policies aimed at reducing the degree of protection currently afforded to some enterprises. At the same time, the social impact of restructuring should be cushioned by improved and appropriately funded safety net policies.

* Completing Privatization. The privatization agenda should be completed, emphasizing, this time, improving governance and competition. First, the voucher privatization scheme under preparation should rely as much as possible on professional asset management, operating under clear conflict of interest rules, and its design should concentrate on avoiding the 'dispersed ownership' results of past privatizations. To this end, key measures would include ix

the supply of an adequate pool of quality assets, and the involvement of a limited number of professional investment fund managers through a transparent and competitive process and with clear rules against conflict of interest. Second, the privatization of public utilities (e.g., electricity and telecommunications companies) should be placed on the policy agenda after addressing the 'natural monopoly' problem present in these industries. These sectors must be open, to the extent possible, to competition and must operate under an adequate regulatory framework. Finally, the Government should pursue more aggressively privatization in the agricultural sector, including unbundling the large integrated 'agrokombinats' and accelerating the divestiture of State-owned land.

* Bank Intermediation. Building an efficient and competitive banking system will require more than resolving the current banking crisis. The 'sound' banks are not profitable enough to withstand lower intermediation margins. There may be too many; moreover, the threat of 'related party' lending is still potentially present in Croatia. The remaining policy agenda is therefore significant, and includes the alleviation of financial repression inflicted by both past Government financial policies and by current monetary policy. The reform should also pursue the removal of unintended de facto barriers to entry, the development of asset-based lending instruments and the strengthening of bank regulation and supervision.

* Capital Market Reforms. Well-functioning capital markets will help strengthen financial discipline of enterprises and improve the efficiency of the overall financial system; such markets will stimulate national savings and facilitate the emergence of adequate corporate ownership structures. There is still a long way to go in this area: the State needs to enhance market security and oversight through the strengthening of market authorities and regulations. It also needs to enhance procedures and institutions to secure property rights and facilitate transactions. It is in this context that the introduction of a fully-funded component in the pension system would result in a major boost for the development of the capital markets.

Transforming the Public Sector

Public finances can and should make a critical contribution to sustainable growth in Croatia. This contribution, however, will be changing over time:

0 In the short-term, the State should fund adequately those spending programs that are necessary to lay the foundations for long-term growth and improve the private investment climate, namely support to structural reforms and reconstruction. Although war-related public expenditure should start decreasing, this phase is likely to entail a reallocation across, rather than a major reduction of, expenditure.

U The completion of this first phase will facilitate a major retrenchment of the public sector. A reasonable goal would be for tax levels to decrease by 10 percent of GDP over a five-to-six year period, thus contributing to the completion of the tax system reform. Lower government consumption would then also permit higher levels of national savings. The State should retrench partly by phasing out war-related expenditure. Reducing the size of the State will also hinge, however, on Croatia's ability to contain, during the initial phase, the ratio of public consumption x and transfers to GDP during the growth phase. For such a strategy to succeed, major structural reforms need to be undertaken in key spending programs:

* Pensions. Croatia can reduce pension expenditure by limiting post-retirement pension adjustments to cost-of-living increases, and by tightening eligibility criteria. The latter reforms would partially reverse, over the medium-term, the recent and spectacular deterioration of the system dependency ratio. The savings generated in this way could be passed on to the private sector through a reduction of payroll taxes. Alternatively, savings could be channeled to capital markets and contribute to their development by transforming Croatia's current pay-as-you-go into a two-pillar pension system, by introducing a fully funded second pillar relying on contractual savings schemes.

* Health Sector. Croatia needs to contain its already high levels of health spending, while continuing to improve the health status of the population: in other words, spend more effectively. Much can be done to this end by reorienting spending towards primary and preventive care and by opening to a larger extent the sector to private sector participation within a carefully-crafted regulatory framework. In the short-term, it will be unavoidable not only to enforce strictly, but to improve, the cost containment mechanisms that have been developed in recent years.

Conclusion

Croatia has shown both remarkable ability and determined economic leadership in addressing and managing crises in the midst of the most adverse circumstances and it has succeeded in implementing one of the most successful stabilization plans in the region. The challenge ahead, however, remains considerable and needs to be addressed with the same determination.

On one hand, Croatia will have to advance in the development of its private sector; this will require deepening the reforms in the banking and enterprises sector, improving corporate governance and downsizing and/or enforcing exiting mechanism for inefficient enterprises. Croatia also needs to complete the privatization process by dealing with the privatization of public utilities. It must do all this, however, while strengthening a legal framework that sets the basis for clarifying and enforcing property rights, in a way that will enhance allocative efficiency, improve the environment for private investment and unleash the potential for a more decisive supply response.

On the other hand, Croatia will have to deal with the reform of its public sector. This entails reducing the size of the government, and easing the current burden of taxation on the private sector, re-orienting public expenditure, containing health expenses without affecting the quality of the service and, fundamentally, reforming the pension system. At the same time, the Government of Croatia will have to handle mounting claims on the public sector in terms of reconstruction, resettlement of refugees, demobilization, and more general society demands for a welfare State. The challenge for the Government will be to resist these pressures to 'consume' the peace dividend and, instead, set priorities with an eye to the long-term horizon.

This report is organized in seven chapters. Chapter I discusses recent macroeconomic developments and summarizes the structural reform agenda for the medium term: microeconomic reforms and public sector reforms. Microeconomic reforms are detailed in Chapter II through xi

IV, starting with an overall discussion (Chapter II), followed by a presentation of structural reforms in the enterprise sector (Chapter III) and in the financial system (Chapter IV). Chapter V outlines a strategy for public sector reform; Chapter VI addresses in greater depth issues and policy measures on the expenditure side while the revenue side is analyzed in Chapter VII.

CHAPTER ONE'

FROM HYPERINFLATION TO GROWTH

1.1 Croatia's transition to a market economy differed in three key respects Box .I: Croatia at aGlance from that of most Central Europe Economy: Croatia is one of the richest of the former republics of Economies (CEEs). First, its former Yugoslavia, with a per capita income equivalent to USS3,900 and GDP economic system, a legacy of the of about US$19 billion. Its output composition resembles that of a Socialist Federal Republic of Western economy, Aunh manufaccuring accounting for only 30 percent of Yugoslavia (SFRY), was significantly GDP (major subsectors include ship)ards, textiles, oil, chemicals and for 60 percenL less centralized than that of other CEEs. agroindustries), agriculture for 10 percent, and services Exports and imports of goods and serices total the equivalent of 95 Second, Croatia became independent at percent of GDP, making Croatia one of the most open economies in the time of transition and thus had to Central Europe. A large part of trade (70 percent) is w%ith Western bear the cost of adding a full layer of economies. government. Third, Croatia was Political system: The Constitution of 1990 establishes Croatia as a immersed in a war immediately after Republic. The president, elected for five years, appoints the Prime independence in 1991, at the very initial Minister and the key Govemnment ofticials. The Parliament elected for four years. comprises a low%er and an upper house. Local administration stages of its transition process. includes municipalities and districts. Its neighbors 1.2 The economic situation during Territory. Croatia has an area of 56.500 square kilometers. are Slovenia, Hungary. the Federal Republic of Yugoslavia, and Bosnia- the immediate pre-independence years Herzegovina. Croatia possesses 1.000 km of Adriatic coastline and 1,185 had already been critical. By that time islands - a major tourist asset. Croatia was in the middle of an Population: Croatia's population was 4.8 million at the time of the last important recession that resulted in three census (19911. including a large Serb minority (II percent of total). An years of decreasing Gross Social unknown but significant part of this minority left the country in 1991-92 Product (GSP) -- an accumulated 11 Conversely, Croatia received up to 350,000 refiugees from Bosnia in still remains close to p tbetween 1987 and 1990 -- and 1992, a population w%hich has now decreased but percent 200,000. In addition, 200,000 displaced Croats left the territories inflation rates exceeded 50 percent per occupied by Serb forces in 1991. An estimated 30.000 have resettled but month by late 1989. The eruption of at least half originate from Eastern Slatonia which is currentK_ under war in 1991 compounded the already international administraiion and expected to revert to Croatian rule in significant problems. As a result, 1991 January 1998. closed with a GDP loss of almost 20 percent, with fiscal and current account deficits equivalent to 5 percent of GDP, and with an inflation rate of approximately 250 percent. At the end of 1993, after six years of an uninterrupted fall in GDP and after having crossed the verge of hyperinflation, Croatia, launched what turned out to be one of the most successful stabilization programs in the region.

1.3 Almost four years have passed since the stabilization program was instituted. Since then Croatia's fiscal stance has remained under control, its foreign reserves have continued to grow, and the

1 Statistical information in Croatia is of uneven reliability. National accounting, in particular, is in the process of being adapted to the standard system of national accounts (SNA-93). Estimates of private sector activity are approximate and this affects the estimation of aggregate consumption and investment. Despite remaining problems in the Balance of Payments information, microeconomic data is, in general, more reliable --including fiscal, monetary, prices, wages and employment information-- although not exempt from problems either. In particular, statistical information prior to 1994 is affected by the 1991-93 hyperinflation and consequently, should be interpreted cautiously. 2 annual inflation rates have not exceeded 4 percent. The economy has attained positive -- though modest - - growth for three consecutive years. After falling by almost 30 percent in 1991-93, GDP growth averaged only 2.3 percent over the last three years, and the recent recovery -- GDP grew by 4.2 percent in 1996 -- owed a great deal to one-time improvements in reconstruction and tourism. Industrial output has not yet recovered in any meaningful way, except for the sectors linked to reconstruction, all pointing to a very slow adjustment to new markets and incentives. Furthermore, the strong recovery of real wages has exceeded productivity gains by a wide margin, thereby increasing consumption and depressing national savings and investment. Accordingly, current account deficits re-emerged during the last two years, averaging 8.5 percent of GDP. The deterioration of national savings and external accounts creates serious constraints for future growth; while unused capacities and efficiency gains can support an initial economic recovery, as was the case in 1996, there is little doubt that national savings and investment will have to increase well above their current levels if long-term growth is to materialize. This Chapter analyses these worrisome developments and concludes that, in order to improve investment and savings, decisive actions should be taken in two areas: microeconomic reform and fiscal reform.

1.4 The investment necessary to restore the country's productive capacity, damaged by war and years of socialist neglect, can be only partially financed through increased foreign investment and borrowing abroad. Ultimately, increasing investment will have to be achieved by increases in national savings that would, in turn, require a deepening of microeconomic and public finances reform. Reforms in the banking sector, privatization of public utilities and strengthening of the legal framework for property rights would together enhance allocative efficiency, improve the investment environment and unfold the potential for a more decisive supply response. Public sector reform, by way of downsizing, civil service retrenchment, reduction of the overall tax burden, and tax reform will further encourage the development of the private sector, easing the current burden of the public sector.

A Particular Transition Economy

1.5 Croatia was born, out of the disintegration of the former Socialist Federal Republic of Yugoslavia whose economic system had collapsed into hyperinflation and recession by the end of the 1980s. The Yugoslav system was, in fact, far more market-oriented than those of the CEEs and the former USSR. Unlike the system prevailing in other CEEs, the Yugoslav system did not rely on central planning, its enterprises were run by both managers and their employees who were free to make their own price, external trade, and investment decisions. Banks were not an instrument for central planning, as in other CEEs, but were owned by enterprises and managed in a decentralized manner.

1.6 The so-called 'self-management' or 'social ownership' system, with its two-tier banking system and free pricing mechanism for most consumer goods, allowed degrees of competition beyond those existing in other CEEs while it avoided -- in general -- the typical shortages of consumer goods characteristic of those economies. Consequently, in comparison with other centrally-planned economies, Croatia presented a relatively developed private sector and a higher share of services -- more than 50 percent of GDP before independence -- in its overall economic structure.

1.7 Despite its decentralization, the Yugoslav system relied on fundamentally flawed incentives: 'social' ownership of enterprises -- effectively that of managers and employees -- and enterprise ownership of banks. This distorted incentive system resulted in persistent wage pressures, poor allocation of resources, and soft budget constraints that turned inflation into a chronic problem. Enterprises owned banks and were consequently able to influence lending decisions, thereby allowing inefficient enterprises to subsist, as their losses were financed through bank loans which were further monetized by the central bank. Two decades of widespread inflation was the direct legacy of this perverse scheme; not 3 surprisingly, the average annual rate of inflation in the twenty years preceding independence was near 70 percent.

1.8 Macroeconomic performance did not differ fundamentally from that of many other centrally- planned economies. The rapid growth experienced during 1950-80 relied on high investment ratios of 30 percent or more, supported by heavy external borrowing. During this period, Croatia achieved a five- fold increase in its GDP, averaging 5.5 percent per year. Nevertheless, when external financing was no longer available to sustain the previous investment levels, the flaws of 'social ownership' became evident. The 1980's international debt crisis caused investment to fall and growth to stall (Graph 1.1), triggering the chain of subsequent financing of losses. Losses in the enterprise sector, in part the result of wage pressures, were accommodated by the banking system through loans that were not repaid, and were then monetized by the monetary authority resulting in a loss of monetary control, and inflation. The successive stabilization programs launched in the late 1980s achieved, at most, temporary effects and were unable to stop inflation as they failed to cut into the roots of the problem by breaking the web linking the State, banks and enterprises.

Box 1.2: Five Years for a 'Normalization' From war to peace. Croatia along with Slovenia declared independence from the SFRY in June 1991 The Gosemment was immediately confronted wiith the de facto secession of the Croatian Serb minority (II percent of pre-independence population i, in areas close to the border with the Republic of Bosnia and Herzegovina and the Federal Republic of Yugoslavia Although these territones were designated as four United Nations Protected Areas ILINPAs) in January 1992, they remained a theater of sporadic hostilities until March 1994. when a cease-fire between the Zagreb Government and the Croat Serb leaders ended hostilities in these areas. Also in March, the 'Washington Agreements' stopped the fighting between Croatia and Bosnian forces, and pro% ided for a federation of Croats, Nuslims and other -loNalisi" Bosnians within Bosnia and Herzego%ina. as well as for a confederation agreement between Croatia and Bosnia. Nevertheless. it was not until mid-1995. that the Government (through military means) regained control over three of the four LNPAs. As to the last UNPA (Eastern Slavonia), an agreement concluded on the side of the Dayton negotiations on Bosnia calls for its return to Croatian rule after a transitional period - under international administraton -- of up to two years. This transitional period is expected to end in Januar, 1998 Economic reintegration. The resolution of the tertorial issues, and the return to peace to the region. have improved Croatia's economic prospects, although the serious challenge of reconstruction remains to be full% addressed The main surface communication links within the country. between north and south, and east and west are now reestablished after four Nears of interruption. Tourism inflows. which had dropped to 10 percent of the pre-%kar levels - up to 10 percent of GDP -- are on their way to recover And the resettlement of 200.000 displaced Croats - 4 percent of the population -- has begun. The main challenge lies in the magnitude of the reconstruction needs, once estimated at "10 percent of GDP b% Croatian officials, and certainly equivalent to 20-25 percent of GDP for'core' programs such as key infrastructure links and the housing stock. Regaining access to international financial markets. Croatia has now successfully regained access to the intemational Financial markets, a prospect that seemed remote at the time of independence In 1991. the countr lost access to its national share of the Federation's foreign exchange reserves, which were kept by Belgrade. Depri%ed of reserves. Croatia had to suspend debt service to most creditors, particularly the Paris and the London Clubs, immediately after independence The accumulation of arrears, and the legal and practical obstacles encountered in allocating the former Yugoslavia's foreign debt to its successor States, explain that Croatia was virtually isolated from international financial markets at a critical juncture. Notable exceptions were the International Financial Institutions, once membership was achieved in 1993. The situation improved dramatically starting in 1995. An agreement was reached with the Pans Club creditors on March 21, 1995, paving the was for bilateral agreements which are not all finalized yet. Negotiations with the London Club were more arduous because of the 'several and joint liability' clause, but were concluded in May 1996. In 1996, Croatia successfully launched two initial public offerings on the London Stock Exchange. In late 1996. Croatia received an investment-grade rating from three major international rating agencies. the grade was equivalent to those received by Poland, Hungary, and the Slovak Republic (Nlood%'s BAA3 and S&P BBB-). In October 1996. the country signed its first syndicated loan agreement in the amount of DEM200 million. In February' of this year, a US$300 million. five-year Eurobond issue received a favorable response in the market. The status of the former SFRY's internauonal reserves, estimated at about USS5 billion at the time of independence. is still under discussion under the auspices of the Interational Conference on Former Yugoslavia 4

1.9 Croatia, like other CEEs at the time of transition, faced the problems emerging from both the change in economic incentives and the loss of traditional markets. The loss in traditional foreign markets came, not so much as a result of the demise of the CMEA,2 as from the interruption in trade with the members of the former SFRY (except Slovenia) as a consequence of the war. Like the other CEEs, Croatia had to: confront the surge in demand for social protection by the State -- particularly as the role of socialized enterprises diminished -- and to address the problem of the nexus between obsolescent enterprises and the banking system. As in the other CEEs, the outcome was predictable: recession, external and fiscal imbalances, and a surge in inflation.

1.10 The war magnified the existing imbalances deeply rooted in Croatia's prevailing economic system and further complicated the already difficult path of transition. In addition to the direct damage inflicted by the bombing, particularly on infrastructure and housing, the indirect economic effects of war were also dramatic. It interrupted the all-important trade flows with the former members of SFRY and seriously hurt Croatia's main export industry: tourism. A key source of foreign exchange before the war, tourism revenues dropped to 10 percent of pre-war levels. Furthermore, Serb control over one-third of Croatian territory resulted in a four-year interruption of the main traffic links between the central part of the country and the east and south, paralyzing the work of the key oil-pipeline from the coast to Central Europe and severely increasing transportation costs.

1.11 The combination of war in the context of transition contributed to a particularly severe recession. Between 1990 and 1993, GDP fell by almost 30 percent while industrial output fell by 50 percent. Public sector accounts were accordingly affected. Defense expenditure, mounting demands for social protection from people displaced by the war, and the unsatisfied demand emerging from the diminished role of enterprises in the social area, all led the State to expand its expenditures to almost 50 percent of GDP.

From Hyperinflation to Stabilization

1.12 The immediate post-independence period was characterized by serious macroeconomic imbalances. In addition to mounting arrears and huge quasi-fiscal losses in the enterprise sector, the fiscal deficit on a purely cash basis climbed to 5 percent of GDP in 1991. The current account of the Balance of Payments swung from traditionally large surpluse to a 5 percent of GDP deficit in the same year, despite a severe recession which led to a plunge in GDP of almost 20 percent, reducing the pre-existing trade deficit accordingly. The lack of foreign reserves and access to external financing further aggravated the balance of payments position.

1.13 With no access to external financing and with very limited possibility of borrowing from the private sector, the large fiscal deficits were financed through domestic bank credits,4 fueling money supply. Inflation accelerated from monthly rates of 5 percent at the beginning of 1991 to 20 percent at the end of the year. With limited sources of financing, the Government of Croatia decided to suspend the service of the

2 Croatia's trade with CMEA countries accounted for only 25 percent of its total external trade.

3 Despite persistent trade deficits, the pre-independence Balance of Payments recorded current account surpluses equivalent to 7-8 percent of GDP, due to continuous surpluses in the service account coming mainly from tourism. 4 With no change in reserves in 1991, these credits were directly financed by issuing new claims on the central bank. 5 outstanding external debt; the sole exception being debt to International Financial Institutions which continued to be serviced.

1.14 In December 1991, the Government of Croatia replaced the Yugoslav dinar with the Croatian dinar (HRD) and implemented a 70 percent devaluation. The attempt to keep a fixed exchange rate regime lasted only three months and had only temporary effects in containing inflation. By March 1992, the exchange rate was managed by dirty flotation and inflation went back to monthly rates between 20 and 30 percent. Inflation levels continued at these levels for the next year and a half, until the stabilization plan of October, 1993.

1.15 During 1992-93, the current account returned to surpluses -- 8.3 percent of GDP in 1992 and 0.9 in 1993. The return to current account surpluses was accompanied by real exchange rate depreciation and a severe deterioration in the purchasing power of household income. Real wages -- including fringe benefits - - dropped by a cumulative 50 percent between 1991 and 1993; while the purchasing power of pensions followed a comparable decline. Household disposable incomes fell by 14 percentage points of GDP in the same period.

1.16 The sharp decline of real wages helped reduce the quasi-fiscal losses of enterprises. Government consumption also decreased and fiscal accounts virtually returned to balance by 1993. The stock of the NBC's international reserves went from zero to an equivalent half billion dollars between January, 1992 and October, 1993. These improvements in the fundamentals underpinned the exchange rate-based stabilization package of October 1993 -- a program that managed to stabilize the currency and drastically reduce inflation.

1.17 Prices fell immediately. Measured by the retail price index, inflation that had reached monthly levels of almost 39 percent in October, dropped to 1.4 percent in November. This was followed by seven consecutive months of deflation. Prices actually declined by 3 percent in 1994 and have increased by no more than 4 percent since (Graph 1.4). The success of stabilization led to a reversal of inflationary expectations and currency substitution, and to a rapid remonetization of the economy: domestic money aggregates increased by more than 90% during the year that followed the announcement of the program, and by 27 percent on average, during 1995-96 (Table 1.1).

1.18 Since 1993, the nominal exchange rate with the Deutsche Mark has served as the key nominal anchor, and its fluctuations have been successfully kept within a narrow band (Graph 1.5). Large capital inflows, in part the result of reverse currency substitution, implied that the exchange rate was subject to pressures to appreciate, rather than depreciate. These pressures were met by purchases of foreign exchange by the National Bank of Croatia (NBC) -- leading to a comfortable build up of reserves (Table 1.1) -- and by sterilization policies.

Emerging Macroeconomic Disequilibria

1.19 It was not until 1996 that industrial productivity in Croatia caught up with its 1989 levels. What held up productivity growth in Croatia was not the lack of adjustment in employment levels: industrial

5 The servicing of the debt with Bilaterals and Commercial Banks was also affected by the dispute over the allocation of the debt of the former SFRY. 6 Inflation measured by the retail price index went from almost 5,000 percent on an annual basis in October to 18 percent the following month. 6 employment dropped7 by 50 percent contributing to rising unemployment and poverty (see Box 1.3). What hindered productivity growth was, in fact, the weakness of the output response. To this day, industrial output has only started to recover, with the exception of those sectors directly benefiting from the reconstruction. Export performance has also been significantly weak. GDP8 grew by a mere 0.5 and 2.3 percent in 1994 and 1995, respectively. Although it increased faster in 1996 -- 4.2 percent -- this performance largely reflected the effects of reconstruction, and the strong rebound in the tourism sector, in the wake of the regional peace settlement, rather than a broad-based economic recovery.

Table 1.1: Croatia: Main Economic Indicators

(percentage change) Real GDP (at market prices) -18.9 -2.1 -2.5 6.0 2.6 4.2 Real GDP (at factor costs) -17.3 -9.0 -3.5 0.5 2.3 4.2 Industrial output -28.5 -14.7 -5.9 -2.6 0.4 3.2 Retail prices (Average) 122.6 663.6 1516.6 97.5 2.0 3.5 Retail prices (e.o.p.) 249.5 937.3 1149.7 -3.0 3.7 3.4 Merchandise Exports (current US$)' -18.1 39.71 -15.1 9.1 8.7 -2.6 Merchandise Imports (current US$)' -26.2 16.51 4.6 12.1 43.6 3.7

(as a percentage of GDP) Current Account of the balance of payments -4.8 8.3 0.9 0.7 -9.5 -7.5 Consolidated Government Expenditures 39.0 37.2 32.6 41.8 46.7 47.2 Consolidated General Government balance -5.1 -4.0 -0.8 1.5 -0.9 -0.5 Total gross reserves2 0.0 0.8 1.7 2.2 2.6

Real Money balances (percentage change) Broad Money -35.4 -18.0 78.0 36.2 44.5 Domestic Money -34.5 -41.1 90.7 16.9 37.5 FX Money -37.2 23.0 67.2 54.9 49.6 Note: 1) Starting in 1992, data include trade with former Yugoslavia, mainly Slovenia. 2) In months' imports G&S, central bank only. Source: CBS, NBC, and World Bank estimates.

1.20 In light of what productivity gains could have supported, the recent recovery of real wages had important implications on both Croatia's competitiveness and the distribution of domestic income. Real wages -- including fringe benefits -- started to rebound in mid-1993 and increased by about 45 percent in 1994 and 30 percent in 1995. Although the 1994-95 increase originated in the enterprise sector, it was promptly emulated in the Government sector, although transfers, particularly pensions, lagged somewhat and eroded relative to real wages. Wage increases were more moderate in 1996 and were supported by productivity gains. From an income distribution standpoint, the wage developments increased household disposable income considerably -- about 12 percent of GDP (Table 1.2) -- and may have had adverse consequences on the level of national savings.

7 Enrollments in the army, and migrations at the time of the dissolution of the SFRY, largely contributed to the adjustment of employment levels. 8 Measured at factor costs, to exclude the impact of rapidly-increasing indirect taxes in 1994-95. 7

The DeteriorationofNational Savings

1.21 Although national and external accounting lack reliability in Box 13: Unemployment and Poverty Croatia, higher household disposable nT official registered unemployment rate was 16.6 percent of the active income boosted domestic population at the end of 1996, while the Labor Force Survey-based consumption and depressed national unemployment rate carried out in November, 1996 - following ILO's savings from its already low levels. methodology - was 10 percent of the labor force. Neither of these reflects The current account, in surplus until that total employment dropped by 20 percent since 1991, representing a loss 1994, swung into a deficit equivalent of 400,000 jobs (see Appendix, Table 2.2). Labor force participation fell from 86 to 70 percent due to early retirement, migration out of the county, to 9.5 percent of GDP in 1995, and and displacement of population. The unemployment rate would be higher if 7.6 percent in 1996. Although this it accounted for displaced persons (who receive ad hoc transfers and are not dramatic deterioration requires counted as unemployed), soldiers to be demobilized, and individuals who qualification, 9 it does point to will rejoin the labor force as the economic situation improves. unfavorable trends with domestic Although there are few social indicators aailable in Croatia (household consumption and savings. Imports surveys were conducted at the federal level under former Yugoslavia and did surged, increasing by over 50 not resume in Croatia until 1996), there is evidence, not surprisingly, of a percent during 1995-96 in dollar significant incidence of poverty. The Croatian Social Protection Fund, wich channels safety net expenditures proper, deals with 240,000 individuals or terms (Graph 1.6). Using cautious about 5 percent of the population. In addition, the Office of Refugees and assumptions,1 0 the current account Displaced Persons has registered 400,000 persons, about one-third of which developments suggest that national (2-3 percent of population) receives subsistence allowances. Although public savings could have dropped from outlays are, overalL well-targeted through means-testing, they entail a about 15 percent of GDP in 1993-94,' 'significant burden on the budget, approximately 2-3 percent of GDP in 1996. to about 9 percent in 1995, and slightly recovered by half percent of GDP in 1996 (Table 1.2).11

1.22 The current level of national savings is a major cause for concern, both because of its potential consequence on macroeconomic stability and its adverse effect on long-term growth prospects. The short-term risk of an external destabilization has been defused, thus far, by capital inflows well in excess

9 Inflows of 'errors and omissions' also surged in 1995-96, to 7.8 and 4.3 percent of GDP, respectively, and contributed to keep the overall balance of payments in surplus. To the extent these inflows reflect in large part, according to the NBC, unrecorded short-term borrowings and the drawdown of savings abroad by households, they confirm the surge of domestic consumption. Moreover, even under the extreme assumption that errors and omissions could be entirely accounted for by unrecorded exports, the current account would still have shown a deteriorating trend, particularly in 1995. 10 For the sake of prudence, we have assumed in this report that about half the amount of errors and omissions reflects unrecorded exports, thus lessening the apparent deterioration in domestic savings. The national accounts shown in the statistical Appendix, however, are consistent with the 'apparent' current account balance and, therefore, show lower savings rates than in Text Table 1.2. 11 With all the caveats related to the imperfections of national accounts, higher levels of household income and consumption clearly appear to have driven the evolution of national savings, although their own savings actually appear to have increased: household incomes simply increased faster than their consumption, by 15 percent, vs about 10 percent, of GDP. In spite of higher wage levels, Government savings did not decrease: they improved by 3-4 percent of GDP, reflecting large increases in tax revenues in the wake of the stabilization. The impact of wage increases was ultimately borne by the enterprise and the banking sectors. 8

Croatia - Selected Macroeconomic Indicators

Graph 1.1: Gross Social Product and Investment Graph 1.2: Output, Employment and Productivity in Industrial Sector co0 (1953-94) 3the

120 500 30% 110 o 25% a 400 - 100 20% 9 0300-- 15% 80so 200 G 70 10% a 60 100 5% 50

0 : 0% 40 1952 1958 164 1970 1976 1982 1988 1994 1/90 9/90 5/91 1/92 9/92 5/931/9494 5/95 1/96 9/96 5/97 195 19 1 98ndustrial Production GSP ndustrial employment lnvestment/GSP ratio - Industrial productivity

Graph 1.3: Productivity, Real Wages and Unit Graph 1.4: Inflation and Monetary Aggregates Labor Costs in the Industrial Sector 140 1200 40 W 120 120- -35 tooo0a + 30 100 00 80 25

600 20 60 1 400 40 10 200 20 -5 -

0 0:.. 0 1/90 9/90 5/91 1/92 9/92 5/93 1/94 9/94 5/95 1/96 9/96 5/97 1991 1992 1993 1994 1995 1996 7-- industrial productivity Annual CPI increase (%) real wages - Broad money (% of GDP) SU Unit labor costs in industry Kuna money (% of GOP)

Graph 1.5: Evolution of Exchange Rates Graph 1.6: Merchandise Exports and Imports 4.5 (in Current Dollars) 2.1 8000- 4 z S1.9 700 3.5 700- 1.7 3 6000 1.5 2.5

1.3 5000

1.1 1.5 ~ 4000

0.0.9- 1 3000 0.7 0.5 2000 0.5 0 2/92 8/92 2/93 8/93 2/94 8/94 2/95 8195 2/96 8/96 2/97 1000 1987 Il 'QALoan,11 -tlop.~'9 JQ 199.4 1995 1996 Real effective exchange rate (based on PPI) 1987 xportsrt SnDoll - Kunas per DM L - Dollar imports 9 of the current account deficits, leading to both balance of payment surpluses and reserve accumulation. 12 These capital inflows may be of an unstable nature, since they reflect reverse currency substitution. A reversal of expectations, or the mere stabilization of money demand, could lead to a partial depletion of foreign exchange reserves, a loss of credibility, and/or to a correction of the external value of the Kuna by the markets. Given the role played by the nominal exchange rate anchor in stabilization, such an outcome would seriously affect price stability.

Table 1.2: Savings-Investment Balances

Total Investment 11.3% 13.8% 14.4% 13.6% 14.0% 14.8% Savings 1/ 11.0% 20.1% 15.6% 14.8% 9.0% 9.4% Savings - Investment -0.3% 6.3% 1.2% 1.2% -5.0% -5.4%

Government Investment 0.8% 1.6% 1.6% 3.3% 4.2% 6.1% Savings -4.3% -2.4% 0.8% 4.8% 3.3% 3.8% Savings - Investment -5.1% -4.0% -0.8% 1.5% -0.9% -0.5%

Non-Government Investment 10.5% 12.2% 12.8% 10.3% 9.8% 8.7% Savings 15.3% 22.5% 14.8% 10.0% 5.1% 3.8% Savings - Investment 4.8% 10.3% 2.0% -0.3% -4.7% -4.9%

Memo items Household disposable income 65.0% 58.9% 51.4% 57.2% 62.5% 63.5% wages 35.2% 24.8% 21.8% 28.4% 31.7% 31.0% budgetary transfers 12.8% 9.1% 8.5% 9.6% 11.6% 12.2% other 11.4% 19.2% 15.8% 13.0% 12.6% 13.8% Recorded consumption of households 44.9% 40.3% 33.6% 43.7% 48.0% 51.7%

1/ See Footnote 9 Source: CBS and World Bank estimates

1.23 In addition to these short-term macroeconomic risks, Croatia needs to address the fundamental issue of its low savings: the single most important constraint to long-term growth. While unused capacities and efficiency gains can arguably support the initial resumption of growth, as happened in 1996 and the first half of 1997, investment levels will undoubtedly have to increase well over the current 14-15 percent of GDP. In the last 15 years, Croatia's ratio of investment to GDP has been steadily declining. Investment levels dropped precipitously during the 1980s, to 10-12 percent of GDP. The war had particularly devastating effects on the stock of national capital. 13 In order for Croatia to achieve

12 In spite of the current account deficits, NBC's foreign exchange reserves increased from 1.7 to 2.6 months of imports during 1995-96. 13 The State Commission for War Damage Inventory and Assessment estimated that the total direct damage inflicted by the war to the national wealth (excluding the damage suffered by Eastern Slavonia) exceeded US$15 billion. The worst affected areas were close to the borders with Bosnia-Herzegovina and the Federal Republic of 10 rapid growth it will have to compensate for the lack of past investment and the war's destruction by achieving investment levels in the range of 21-22 percent of GDP in the medium term.

1.24 Considering the investment effort ahead, the current level of savings in Croatia is disturbingly low and leaves a potential gap of at least 7 percent of GDP. At 9% of GDP, it is significantly less than that of the Czech Republic and Slovakia (26%), Poland, Romania and Slovenia (22%), and Hungary (20%). Although Croatia has now regained access to international financial markets, several factors will combine to limit international contribution to Croatia's potential financing needs. The evolution of DFI may be affected by political developments in the region as well as the fact that privatization is not emphasizing strategic investment. DFI flows came to a halt in 1991-92 and picked up to a modest 0.5 percent of GDP after 1993. In 1996, however, DFI inflows increased four-fold in dollar terms, reaching an equivalent 1.8 percent of GDP. This Report assumes that DFI annual flows will continue to increase up to around 3 percent of GDP p.a. within a three-year period -- the average performance observed in other CEEs. Second, excessive reliance on external debt to finance higher investment levels would exert pressure on the current account, resulting in deficits that could reach or exceed the average level recorded in 1995-96 -- approximately 8.5 percent of GDP. This could, as stated above, undermine external and domestic confidence in the soundness of macroeconomic policies and, in turn, have destabilizing short- term effects.

1.25 Croatia's foreign debt is currently at a comfortable level of 25 percent of GDP, on the lower end of the CEEs. Admittedly, there is room for certain reliance in foreign financing, yet debt dynamic considerations suggest a careful use of this source of financing, particularly since excessive reliance on external borrowing to finance the necessary investment could have negative effects on Croatia's indebtedness and creditworthiness. A reasonably high growth scenario, supported by rising investment levels, would increase the ratio of external debt to GDP from 25 to 60 percent of GDP by the year 2004, if national savings were to increase only marginally (Table 1.3 - Scenario 3). If instead national savings increases from 7 to about 15 percent of GDP over the period, external debt would still rise to almost 50 percent of GDP. Only if savings could reach 19-20 percent of GDP would external debt stabilize at approximately 24 percent of GDP, after a temporary increase. These constraints suggest that reliance on external savings, including DFI, should not exceed, on average, about 5-6 percent of GDP over the medium-term. Under these circumstances, how can Croatia increase savings and investment to the levels necessary to spur long-term growth? Answering this question requires, first, a better understanding of the root causes of the disequilibria that are emerging in Croatia.

The Sources of the Emerging Disequilibria

1.26 The essence of Croatia's current problems lies in a combination of strong real wage growth coupled with insufficient advances in productivity. The resulting loss in competitiveness can be found at two different levels: first, at the microeconomic level, Croatia has been slow in implementing the structural reforms that elsewhere have improved allocative efficiency and generated 'quick' growth and productivity gains. Second, at the public sector level, the size and the structure of Croatian public finances have helped to depress savings and dampen growth.

Yugoslavia; that is in Slavonia, the "Krajina" and the area surrounding Dubrovnik. Nevertheless, not even Zagreb could avoid the war-time destruction. 11

Supply Side Issues

1.27 The sluggish adjustment of the supply side to the new markets and incentives, including the lack of wage discipline, has been a distinctive feature of Croatia's recent economic history. Admittedly, some of the 'quick gains' that helped other CEEs rebound after the transition, were not available to Croatia. Liberalization of the service sector has contributed significantly to initial growth in many transition countries but this sector had never been repressed to the same extent in Croatia; it already accounted for 50 percent of GDP before 1991. Similarly, there was less room for a reorientation of trade flows: 75-80 percent of Croatian exports, the equivalent of 25 percent of GDP, was directed to Western markets before independence. Nonetheless, the inability of Croatian enterprises to meet the strong recovery of domestic demand in 1994-95 points to profound inadequacies in the structure of supply. The large and worsening losses recorded by Croatian enterprisesl 4 account for a substantial part of the deterioration in national savings. Moreover, there is little evidence that those Croatian enterprises which lost access to the former 'soft' SFRY markets have started to adjust in any significant way to the new situation. As mentioned, real exports and industrial output have basically stagnated, in the aggregate, since 1993. Even more disturbingly, export and output performance have, with a few exceptions, not shown fundamental differences across subsectors (Graphs 1.7 and 1.8), pointing to a very slow adjustment to the new incentive framework and market structures.

Table 1.3: Three Financing Scenarios

1997 1998 19969 2000 2001 2002 2003-06 Common Assumptions Growth of GDP (% p.a.) 4.3 4.5 5.0 5.5 5.5 5.5 5.5 Investment/GDP 15.7 17.6 18.3 19.2 20.1 20.9 21.5 Foreign Direct Investment/GDP 1.8 2.0 2.4 3.0 3.0 3.0 3.0

As a Percent of GDP Scenario 1 National Savings 7.2 9.7 13.2 15.9 17.7 18.8 19.5 Current account balance -8.5 -7.9 -5.1 -3.2 -2.4 -2.1 -2.0 External Debt 28.0 31.9 33.2 32.2 30.0 27.8 24.1

Scenario 2 National Savings 7.2 9.5 10.6 11.9 13.1 14.0 14.6 Current account balance -8.5 -8.3 -7.8 -7.3 -7.0 -6.9 -6.6 External Debt 28.0 33.2 37.9 41.5 43.5 45.4 48.5

Scenario 3 National Savings 7.2 9.5 10.1 10.1 10.7 11.2 11.4 Current account balance -8.5 -8.1 -8.2 -9.1 -9.4 -9.7 -10.1 External Debt 28.0 33.8 38.4 43.2 47.4 51.6 60.4

In the aggregate, enterprises recorded losses equivalent to 6 percent of GDP in 1995. Profit-making enterprises recorded positive results equivalent to 4 percent of GDP, which were more than offset by the negative results of loss-makers (equivalent to 10 percent of GDP). Aggregate losses were 4 percent in 1994. 12

1.28 The moderate to low process of adjustment is related to both deficiencies in enterprise governance as well as to the continuing existence of soft-budget constraints. Enterprise performance has been closely correlated to ownership structure (Graphs 1.9 and 1.10). Whereas the emerging 'new' enterprise sector has made a positive contribution to output growth and profitability, those enterprises remaining under State control have performed poorly and contributed to holding back Croatia's overall economic performance. Privatized enterprises appear to stand between these two groups, and this raises the issue of the efficiency gains yielded by Croatia's privatization model. Indeed, as will be discussed in more depth in Chapter II, many enterprises, including the privatized ones, still appear to lack an effective owner. Although the process of privatization started early after independence, and was completed for as many as 2,500 out of 2,700 previously socially-owned enterprises, the process placed a strong emphasis on employee and management participation. This biased the process toward the privatization mostly of smaller enterprises, and may not have fundamentally improved governance and incentives in many of the new 'private' entities. In a number of them, an extremely fragmented ownership structure and the absence of any large, profit-oriented owners has allowed the old management to collude with employees in order to retain their power. As suggested by recent enterprise performance, Croatia's privatization model may have perpetuated, in a number of enterprises, the flaws of the previous system of governance, including the lack of incentives to maximize performance and the vulnerability to wage pressures.

1.29 The 'insider privatization' model has also left most of Croatia's largest enterprises, including the large infrastructure and utilities companies, in State hands. 15 While relatively few in number (200), these enterprises account for a disproportionate part of the losses recorded by the enterprise sector. They belong, more often than not, to the large subset of enterprises that operated, before independence, on the 'soft' SFRY markets. Constrained as they were by wage pressures and low domestic and external savings, many of them have failed to upgrade their stock of capital equipment for at least two decades. With the collapse of their traditional markets, they are saddled with outdated and oversized facilities that entail high fixed costs and produce lower quality goods which do not find their way into Western markets. The State-owner has failed to improve the performance of these firms in any discernible way and, indeed, has allowed many of them to continue operating under soft budget constraints. These soft budget constraints include (see Chapter II): selective trade barriers and subsidies, although Croatia fares better than many other CEEs in this respect; implicit cross-subsidization resulting from complex conglomerate structures; State-led enterprise 'restructuring' schemes that are akin to outright bailouts; and, most importantly, a banking system whose reform has just started.

The structure of the banking system is, indeed, largely to blame for the continued existence of a 'soft' budget constraint on parts of the enterprise sector. Although opened to new private entrants after 1991, the banking system remains dominated by a small number of large institutions that pre-date independence. These banks were typically owned by enterprises, a legacy of the former SFRY system, and engaged in widespread related-party lending. There is thus a close correlation between troubled enterprises, problem bank loan portfolios, and bank owners, either because enterprises owning banks have influenced poor lending decisions in the past, and/or because banks have no incentive to impose financial discipline on their troubled customers/owners. Croatia did not begin to tackle this issue until 1996, and has not yet managed to harden budget constraints on loss-making enterprises in a consistent way. Attempts made at stemming 'new' lending to loss-making enterprises have been only partly successful: they targeted only the largest corporate entities, which could circumvent those restrictions through interenterprise credit, most often through subsidiaries of a same group.

15 When not privatized, enterprises were systematically commercialized. Hence, the State became their direct owner. 13

Croatia: Selected Indicators of Enterprise Performance

Graph 1.7: Evolution of Output across Industrial Graph 1.8: Evolution of Exports by Industrial Subsectors Subsectors 0 700

. El0

700

60 30

0 150

0e Cl 40

1989 1990 1991 1992 1993 1994 1995 1996 4440 1001 1009 1449 sq 10qq 1an Oil - Iron & steel Oi, total fron & steel Metal products ----- Machine industry Metal products --- W---- Machine industry Shipbuilding -4--- Elect. equipment ---- Shipbuilding - Elect. equipment -Basic chem. prod. Chemical products . 0 Basic chem. prod. - Chemical products -)- Building materials - - * - - -Timber industry -'Building materials - - r --*Timber industry 0 Finished wood prod. "Paper -0--- Finished wood prod. - Paper *msmmTextile products ---- Food products Textile products ---- Food products

Graph 1.9: Enterprise Pre-Tax Profits (Losses) by Graph 1.10: Enterprise Pre-Tax Profits (Losses) by Ownership Structure (in % of GDP) Ownership Structure (in Kunas per Capita)

C

90 X 2 10 0 0

*~ .00. a.0Za ...'i

C. UL L 50 0 ------2 10000

0 a o - -505000 -- a ------*------

0 0- -5000 ---

---- ______- It-10000

-2 -l -15000 -- ______~--

-25000 ------

-30000 - ---

-5 - -35000 ------

-6 01994 1995 -40000 -6 E31994 121995 1 0000_0101994 994 _ *819951_1995 14

Public FinanceIssues

1.30 Enterprise competitiveness and efficiency have also been affected by developments in Croatia's public finances. With public expenditure rising from 33 to 47 percent of GDP in the last 3 years (Table 1.1), the size of the public sector is comparable to that of the more affluent OECD economies and at the higher end of the range for transition economies. While high tax levels tend to reduce incentives to produce and save, the problem in Croatia has been compounded by the magnitude of non-productive spending on the expenditure side and by delays in tax reform.

1.31 On the expenditure side, the issue goes beyond war-related spending, which was admittedly imposed by circumstances. The corresponding military, and other war-related programs have preempted up to 20 percent of GDP in the past and have crowded out growth-enhancing expenditure, such as public investment or support to structural reforms. Although they have now subsided to about 10 percent of GDP,16 there is clearly room for further savings in this area. Even more disturbing is the recent increase in Government wages and social expenditure which accounts for much of the recent explosion of public expenditures. In contrast to the other countries of the region, Croatia was initially able to reduce spending on social and economic programs, partly because of the need to finance the war effort. During 1991-93, the Government's wage bill decreased by 1 percent of GDP; pension and health expenditure, which are financed through payroll taxes also decreased from 21 to 15 percent of GDP.

1.32 The above-mentioned dynamics, however, have recently reversed. Pension expenditure increased from 7 to about 10 percent of GDP during 1993-96. This surge reflects the lagged effect of a sharp deterioration in the system dependency ratio -- mostly on account of early retirements generously allowed during 1991-93 -- that was initially offset by the drop of real wages and pensions. Despite the elimination of automatic wage indexation, the rebound of real wages has led to one-time increases in pension awards, and threatens to place pension expenditure on an explosive path. A similar development is taking place in the health sector. Through an earmarked payroll tax, real wage increases provided an automatic 'revenue escalator' for the Health Fund. Health expenditure has increased from 7 percent of GDP in 1993 to approximately 9 percent in 1996, giving Croatia one of the highest share of Health expenditure in Central Europe, notwithstanding the cost control mechanisms it introduced in 1994.

1.33 Despite the sharp increase of public expenditure, the net fiscal position has been maintained close to balance until now (see Table 1.1): revenues have kept up with expenditure, thanks to the positive effects of stabilization, and to selective increases in tax rates. Nonetheless, both the high current taxation levels and the distortionary effects of the current tax system hamper the evolution of the real sector. The overhaul of the existing tax system -- in particular, the introduction of the VAT -- has been delayed for fear of an untimely loss of revenue.

1.34 The bulk of public revenue is still generated through unreformed, distorting taxes that are a holdover of the earlier system. Although the Government did introduce modern personal and corporate

16 Officially-recorded spending on defense -- without including a related fraction of spending on police and public order, equivalent to 3 percent of GDP -- peaked at 12 percent of GDP in 1995, or about 50 percent of the Central Government outlays. Other budgetary programs have also been inflated on account of the war. For instance, support to displaced persons and refugees entails an annual cost of about 1 percent of GDP p.a.; subsidies to the railway company, which operates at one-third of pre-war traffic levels, are 1.5% of GDP p.a. War-related spending still absorbs about 10 percent of GDP in the 1997 budget: 7 percent on defense proper, part of 2-3 percent of GDP allocated to police; 1-2 percent on various programs, such as refugee support. 15

income taxes in 1994, these taxes yield only a modest 4-5 percent of GDP. Revenue from the corporate tax, in particular, hardly reaches 1 percent of GDP, reflecting low enterprise profitability. The introduction of the Value Added Tax (VAT) was postponed twice,17 in part because of persisting pressures on the fiscal accounts. As a result, over 20 percent of GDP, or about 50 percent of the General Government's revenues, are generated by indirect taxes that involve multiple rates and at least some cascading. In addition, high payroll taxes (16-17 percent of GDP) help distort output choices and labor incentives. Increasing tax pressure has led to significant levels of tax evasion; it has encouraged the development of a large informal sector and, in this way, has compounded tax pressure on the formal economy. Despite encouraging initial results, the tax administration may still need further build-up, particularly in the audit area, to achieve a higher degree of tax compliance.

From Stabilization to Growth - The Medium-term Policy Agenda

1.35 For Croatia to achieve sustainable growth rates of 5-6 percent p.a. as targeted in our medium- term scenario (Table 1.4), the medium-term agenda must include three main objectives within the next 3- 4 years. First, Croatia must achieve investment levels of 21-22 percent of GDP -- almost 80 percent of it by the private sector -- to support gains of productivity and to improve external competitiveness. Second, if private sector-led investment is to become the main engine of long-term growth, the microeconomic foundations of such growth will have to be restored: improving governance and performance in enterprises and the intermediation system will be key to reducing the level of interest rates, stimulating investment demand, and maximizing the efficiency of future investment decisions. In parallel, the overhaul of the tax system needs to be completed to eliminate the tax-induced distortions that continue to bias output and factor allocation decisions. Finally, Croatia will have to finance internally a large part of its investment effort in order to contain its external debt and current account deficits within sustainable levels. This scenario implies that national savings will have to increase significantly, to about 19 percent of GDP.

1.36 Given recent developments, this national savings target seems challenging. It can be met, however, if Croatia manages to spur a sufficient short-term recovery. Croatia will need to expand GDP growth rates to 5-6 percent p.a., while at the same time containing the growth of domestic consumption to about half the growth of GDP. The implementation of microeconomic reforms will help achieve this dual objective, by reducing the dissavings generated by loss-makers, by reinforcing wage discipline, and by improving the allocation of existing resources. All together, these reforms could improve national savings by 4-5 percent of GDP and also foster short-term growth. Nonetheless, they would need to be complemented by a comprehensive public finance strategy aimed at the same objectives. Over the medium-term, Croatia should foster savings through a significant reduction of public expenditure, to around 40 percent of GDP; this will also facilitate the completion of the tax system reform. In the short- term, however, public finance must prioritize funding for key expenditure programs: support to reconstruction and to structural reforms. These programs are needed to enhance short-term, as well as long-term growth and must be carried out immediately, even at the cost of delaying public sector retrenchment by as much as two years.

17 The VAT legislation was enacted in 1995 and its application initially postponed from 1996 to 1997. In November 1996, the Government decided to delay further the implementation of this reform which is now expected to become effective in January, 1998. 16

Table 1.4: A Medium-Term Scenario

Real Sector Growth of GDP 4.3% 4.5% 5.0% 5.5% 5.5% 5.5% Growth of consumption 3.9% 2.1% 2.7% 3.4% 3.5% 4.7% Public investment/GDP 6.8% 8.0% 8.0% 7.0% 6.0% 5.3% Private investment/GDP 8.9% 9.6% 10.3% 12.2% 14.1% 16.2% National savings/GDP 7.2% 9.7% 13.2% 15.9% 17.7% 19.3%

Public Sector Government Expenditures/GDP 50.5% 51.0% 48.0% 44.0% 41.0% 39.0% Government deficit/GDP 3.0% 3.0% 3.0% 2.0% 1.0% 1.0%

External Sector Current account balance/GDP -8.5% -7.9% -5.1% -3.2% -2.4% -2.0% External debt/GDP 28.0% 31.9% 33.2% 32.2% 30.0% 24.7% Central bank reserves (months imports) 2.9 3.1 3.3 3.4 3.4 3.4 Source: World Bank

Microeconomic Reforms

1.38 A viable medium-term strategy for growth will have to address the problems of inherited social enterprises and the financial sector insolvency associated with it. As mentioned, privatization in Croatia has yielded mixed results and is still incomplete. The resolution of the bank-enterprise nexus, the key source of soft budget constraints, has started only recently. The outstanding reform agenda is therefore significant, and should be implemented swiftly, along three main paths:

U As a matter of priority, Croatia needs to emphasize the long overdue downsizing, or exit, of large loss-makers. The sheer amount of the gross losses recorded by Croatian enterprises -- 10 percent of GDP in 1995 -- suggests that substantial gains in terms of national savings, perhaps 4-5 percent of GDP, could be easily achieved by dealing with the most obvious candidates for restructuring. More decisive action in this area is now possible since the bank restructuring program has started in earnest but has yet to be effectively implemented. Chapters II and III will argue that, given the concentration of the problem in a handful of banks and large enterprises (e.g., INA, the shipyard sector), and the unhealthy ownership links between the banking and the enterprise sectors that prevailed until very recently, a partially centralized approach will achieve faster gains than simply letting banks, or the judicial system, resolve the problem. Relieving troubled banks from the worst aspects of the legacy of the past should, in turn, speed up their restructuring and facilitate their early privatization, leading to substantive improvements in the cost and the efficiency of intermediation.

0 In a parallel way, the enterprise privatization agenda should be completed, but this time, putting more emphasis on enhancing governance and competition. These two objectives are particularly pressing in the case of the large public utilities which, thus far, have not been open to privatization. Improving enterprise governance should also underpin the Government's current efforts to dispose of other enterprises whose privatization is underway but has stalled. With this in 17

mind, Chapter III will also propose specific measures to enhance the effectiveness of the voucher privatization scheme currently under preparation.

U The development of capital markets is particularly important in Croatia, since it will not only strengthen financial discipline and improve the efficiency of the overall financial system, but it will also help to restructure, over time, the inadequate ownership structure in a number of enterprises. Croatia urgently needs to enhance market security and oversight through the strengthening of market authorities and regulations. It also needs to enhance procedures and institutions to secure property rights and facilitate transactions. In addition, the public sector could also boost capital markets development by fostering institutional investor demand, particularly by introducing a fully-funded element into the current pay-as-you-go pension system. Chapter IV discusses these financial sector policies.

1.39 Although the Croatian authorities agree in principle with these reform objectives, their main achievements have been, until recently, related to the institutional framework and diagnostic work, while actual implementation is only starting. One of the reasons for slow progress is the up-front costs of structural reforms which, due to severe tensions on the fiscal front, have led authorities to slow their reform agenda. As implementation begins in earnest, the fiscal situation might also lead authorities to give preference to a 'gradualist' scenario which could not only seriously threaten the success of the reform program itself but ultimately increase net costs to the budget.

PublicFinance Reform

1.40 The uncertainties affecting bank and enterprise reform are one illustration among many of how public finance needs to undergo in-depth adjustment. Croatia must radically transform the role of its public sector and allow it to foster, rather than hamper, growth. Considering Croatia's current circumstances, our scenario distinguishes the medium-term vision, approximately three years into the future, from the next 2-3 years (Table 1.4). Over the medium-term, public expenditure should decrease from 50 to approximately 40 percent of GDP. To achieve this, Croatia will need not only to phase out war- related expenditure -- 4 to 5 percent of GDP -- but also to contain the increase of other spending programs, particularly health and pension expenditure, to about half the growth rate of GDP. In the short-term, the public sector must accommodate priority spending programs such as the reconstruction and resettlement effort, as well as the up-front costs of enterprise and bank restructuring. These programs are critical not only to unleash growth but to effectively phase out war-related expenditure.18

U As discussed in greater detail in Chapter V, the short-term needs may entail incremental costs of 4-5 percent of GDP p.a. Assuming some inertia on the military expenditure side, these additional outlays are likely to preclude, initially, any major reduction of taxation levels. The Government might even need to incur somewhat higher fiscal deficits, that would have to be kept in line with the external financing available (2-3 percent of GDP) in order to minimize inflationary pressures.

U Regarding pensions, the tightening of eligibility criteria being considered by the Government can generate savings of 2-3 percent of GDP after 4-5 years, if post-retirement pension

18 For instance, phasing out budgetary transfers to displaced persons or reduction in soldier's on the army's payroll implies reconstruction in the territories previously occupied. The same rationale applies to the elimination of subsidies to the railway company which still operates at one-third of pre-war traffic. 18 adjustments are contained at, or below, GDP growth rates. As discussed in Chapter VI, these savings could be used to reduce the current level of payroll taxes, or, preferably, to finance the introduction of a fully-funded component in the current pay-as-you-go pension system, thereby channeling additional financial savings into capital markets.

U In the Health sector, although the 1993 cost-control measures brought about marked improvements, they have not fully addressed the underlying causes of expenditure increases. Chapter VI will suggest additional reforms, with a view to contain, and enhance the effectiveness, of spending on health care.

U If successfully achieved, the reduction of public expenditure will not only authorize a substantial reduction of tax pressure, but will lift the major constraint that has held up the full overhaul of Croatia's tax system until now and that has perpetuated distortions in output and factor decisions. The agenda for tax reform is large and includes: first, the implementation of the new VAT; second, the reduction in the level of payroll tax rates in order for Croatia to be in line with its international competitors; and, finally, equity considerations call for substantial progress in tax administration, and compliance. Chapter VII elaborates further on these reforms. PART ONE

CHANGING INCENTIVES

CHAPTER TWO

HOW TO FOSTER THE SUPPLY RESPONSE?

2.1 The recent recovery of GDP has a narrow sectoral base: reconstruction and tourism account for most of the increase in activity. While these sectors may contribute Croatia's enterpnse sector has experienced a profound to further output gains, particularly in 1997, transformadon over the past six Nears. The pm% ate sector share in they do not imply that Croatia has entered a sales or employment, which was less than 5 percent in 1990. had cycle of sustained growth. Indeed, output, grown to about two-thirds by 1995 (Table 2.1 and 2 2). In the economy as a whole, one out of two employed Croats was investment, and profitability levels have working for a private enterpnse, compared to one out of se%en in deteriorated, or continued to stagnate, in 1990. This remarkable evolution is due to two parallel large segments of the enterprise sector. developments, almost of equal importance. Fust, the full Enterprise performance, however, varied liberalization of enry requirements after independence unleashed an impressive growth in new priNate enterprises. By December widely across different subgroups, in a way 1995. the number of privately-established enterprises effectively that was closely correlated to ownership in operation had increased siN-fold (to 56.000 urnis). and their structures. Croatia's enterprise sector share in enterprise sales and employment reached 38 and 23 underwent profound transformations during percent, respectn%ely. Second. Croatian authonties have the past six years: the 'new' private pratized about half by employment or sales measures. of the 'socially-owned' enterprise sector that used to produce most enterprises and privatized enterprises have goods and services under the former Yugoslavia. Croatia's grown to account each for approximately enterprise sector now comprises three subsets of similar weight- one-third of sales and employment, with the state-owned, privatized and 'new' enterprises. share of publicly-owned enterprises A word of caution. Enterprise sector statisucs. as in many shrinking commensurately (Box 2.1 and transition economies, are not ver reliable and detailed Graphs 2.1, 2.2). While recent enterprise infonnanon that would permit a thorough sectoral anal)sis is performance has been dismal, it has also una% ailable or eonsiderabl delaN ed. been very uneven across these three segments. Private enterprises fared considerably better than publicly-owned enterprises as measured by profitability (Graphs 2.3 and 2.4), sales per capita (Graph 2.5), and increase in real sales1 9 (Graph 2.6). Within private enterprises, the performance of privatized companies was less impressive than that of the 'new' private enterprises, but still contrasted sharply with that of publicly-owned enterprises 20 .

19 The ongoing privatization has caused many enterprises to move from one category of ownership structure to another, making it difficult to trace precisely the performance in terms of sales (beyond the breakdown of 'new' enterprises, and 'others'). Available data until end-1995 suggest, however, that privatized enterprises have been performing better than publicly-owned ones in this respect. 20 The problems in large loss-making State-owned enterprises are even greater than suggested by their losses. First and foremost, some were not fully servicing their external debts, and their losses would be higher by about 1 percent of GDP if these obligations were factored in. Second, part of their capital stock was destroyed during the war, particularly in the case of the railways company, the electricity company, and INA. Low or negative profitability makes it impossible for these enterprises to finance the necessary investment programs that they should be undertaking. Third, break-even results or moderate losses mask possible cross- subsidization between profit- and loss-making activities within the same group; the complex structure of some of these enterprises makes it difficult to impose financial discipline (profit-making entities finance, out of their own or borrowed funds, loss-making ones), and perpetuates less than optimal factor allocation. 22

Croatia: Selected Indicators of Privatization and Enterprise Performance by Ownership Structure

100% -- Graph 2.1: DIstribution of Sales 100% - Graph 2.2: Distribution of Employment. 90% 90% 80% 80% 70% 70% 6%0%

40% 40% 30%

20% 10% 10% 0% I-I---IL 0% 1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1994 1995 0 Majority Public P0 Public Sector UMajoity Private Fully Privatized Majority Private GFully Privatized 0New Private W New Private

Graph 2.3: 1994 Pre-Tax Results Graph 2.4:1995 Pre-Tax Results

4 4

2 Aggregate Loss-makers Aggregate Loss-maker 0 Profit-makers 2 Profit-makers (5 0- Lrjj 1 t- Laer

-6

10-1 -101 -12L 0 Public Sector 0 Majority Public 0 Public Sector GMajority Public DMajority Private N Fully Privatized B Majority Private W Fully Privatized UNew Private NTotal UNew Private NTotal

Graph 2.5: Sales per Employee Graph 2.6: Changes in Real Sales

0.65 40000

350000 0.55

1300000 C~ 04504 500

00000 0.35

:150000 0.25 100000 0.15 50000 0 0.05 1994 1995 OPublic Sector 0 Majority Public -0105 lePv UMajority Private 8 Fully Privatized aNw Private U New Private EAverage CAll enterprises 23

2.2 Why did State-owned enterprises perform so poorly, and why did the 'new' enterprises do better than the privatized ones? This chapter argues that this has much to do with insufficient progress on the structural reform front. First, Croatia's 'insider privatization' model had mixed effects on the governance of privatized enterprises, and left the largest Croatian enterprises Linder less than effective State control. Second, distortions in the incentive framework, essentially the trade regime, have shielded from competition public enterprises. Finally, until late 1996 when the ongoing program of restructuring of the largest State banks entered into full swing, some of these enterprises were allowed to operate under 'soft budget constraints', particularly those resulting from their former cross-ownership links with the banking system.

Governance Issues

2.3 Croatia has been successful at moving away from social ownership 21, and advancing privatization. Under the Law on the Transformation of Socially-Owned Enterprises of 1991 (see Box 2.2), virtually all socially-owned enterprises have been commercialized, most of them as early as 1992-93. Considerable progress was also made with privatization which, as of mid- 22 1996, was completed for 89 percent of commercialized enterprises , accounting for 60 percent of the equity, 50 percent of sales, and 45 percent of employment, of the 'privatizeable' enterprises (Table 2.1).

Box 2.2: The 'Transformation La%*

The Law on the Transformation ot Socially-owned Enterprises. enacted in 1991 (the 'Transformation Law'), covered all socially-owned enterprises, with the excepion of 10 large infrastructure and utiUties enterprises which came under direct State ownership and municipal public services. Socially-owned enterprises were given one-year to transform into joint-stock companies and, at their ophion. to submit a privatization plan. Relatively generous discount and installment payment features were intended to encourage the population. particularly employees, to participate in privatization. Employees and former employees had priority rights for subscribing up to D120,000 (about US$15.000 equj%alent) of shares up to 50% of the enterprise's equirN at a discount and wth the option of deferred payments (at that time, up to fiLe years). The discount, a basic 20 percent plus one percent per year of ser ice. reached 40 percent on average. All employees of the public sector had the same rights to discounts and deferred payments for subscribing shares of the enterpnse of their choice, immediately after the employ ees of each firm had exercised their preference rights.

Of the shares unsold after this first stage. one-third was allocated to the Pension Fund. The remaining two-thirds were transferred to a Goernment agency. the Croatian Privatization Fund (CPF) for privaiizaLon through other methods. Lenders for large blocks of shares, or negotiated deals with large inestors; auctions of small packages of shares for cash or for frozen foreign exchange deposits: swaps by which enterprise credicors, mostly banks, converted their claims in shares.

2.4 These results are impressive, but do not tell the whole story. Privatization policies delivered fast results because they relied heavily on the acquisition of enterprises by insiders: managers and employees were given strong incentives to purchase, in the form of generous discounts and possibilities for deferred payment (Box 2.2). The result was, on the one hand, a

21 The lack of clear enterprise owners, the influence of employees on day-to-day management, and wage pressures were the 'Achilles heel' of many socialist economies. In former Yugoslavia, this syndrome took the form of 'social ownership': ownership rights belonged to 'the society' (i.e., to no clearly identified owner) while day-to-day management was in practice entrusted to Boards of Associated Labor, a combination of employees and managers. 22 Of a total of 2,557 enterprises, 2,287 were privatized, of which 1,145 are fully-privatized. The state retains on average 40 percent of the equity in the other 1,142. 24

very high degree of popular ownership (Table 2.1), with 640,000 small shareholders 23 purchasing 76 percent of the shares sold by the State24, and owning each about US$10,000 worth of shares on average. On the other hand, Croatia's 'insider' privatization model may have had mixed effects on the governance of privatized enterprises, as suggested by their mediocre performance, and has left in State hands most of the largest enterprises, whose privatization has so far been very slow.

PrivatizedEnterprises

2.5 The 'popular' ownership resulting from the past privatization policies raises something of a 'principal-agent' problem. The new ownership structure of privatized enterprises, in many cases, has left managers virtually unaccountable to the shareholders, for three reasons. First, ownership structures are extremely dispersed among small shareholders: in fully-privatized enterprises, 86 small shareholders hold 87 percent of the share capital, on average; in majority- privatized enterprises, 340 shareholders hold 44 percent of the share capital 25. Second, anecdotal evidence suggests that a number of employee-shareholders subscribed to shares in their own companies as a way to secure jobs and improve remuneration levels, rather than with any investment perspective. This attitude was sometimes encouraged by managers themselves 26. Furthermore, shares were often purchased on installment, and turned out, in a number of enterprises, to have been overvalued. Finally, strategic or dividend-motivated investors, which could have fulfilled more of a monitoring function, very seldom hold a significant, much less a controlling, stake in privatized enterprises 28.

2.6 Dispersed shareholding need not remain a long-term obstacle to enterprise governance, provided an adequate securities market framework is fully established, and ownership structures are allowed to evolve over time. So far, however, secondary trading has remained quite limited. Out of 697,000 share purchase contracts from CPF, 93,000 or 13% had been officially recorded as transferred to other investors on the 'secondary market'. Besides the overall political and economic situation, specific factors contributed to hamper secondary trading: serious deficiencies

23 Thirteen percent of the population, and possibly up to 30-40 percent of households. 24 In the case of majority-privatized enterprises, 72 percent; 93 percent in fully-privatized enterprises. 25 This is equivalent to 72 percent of the privatized share capital. 26 For instance, managers seeking to retain their jobs in the privatization process have encouraged their employees to subscribe shares and 'invited' them to issue full proxy voting rights for shares, unlimited in scope or time, or rights of first refusal in the event of sale. Although the establishment of rights of first refusal are now illegal under the new Companies Law, the problems related to wholesale giving away of proxy rights remains an issue. 27 An overwhelming majority of these shares were purchased under a five-year installment plan and are only partly paid for, even to date. As it became evident that many purchasers could not pay, payment obligations were first backloaded within the five-year period (in 1993), then rescheduled over 20 years across- the-board, by the new Privatization Law of 1996. Shares subscribed but not paid for give the right to vote, but not to perceive dividends, to their owners. Shareholders unable to make payments under the new 20-year schedule will have to return their shares to the Croatian Privatization Fund. 28 Fully-privatized companies have, on average, 4.4 large investors which, together, hold 7 percent of the share capital. Majority-privatized companies have, on average, 4.3 large investors which, together, hold 15 percent of the share capital. 25 in title registration; the overhang of deferred payments (and confused perceptions) on the status of subscribed but not fully paid shares; the overvaluation of shares acquired under the Transformation Law; and the lack of an institutional and regulatory framework for securities market in general. Only in 1995 did a new pattern start to emerge, with foreign and some local strategic investors beginning to acquire simultaneously shares from employees together with blocks of shares from CPF's portfolio.

State Enterprises

2.7 Unfinishedprivatization agenda. The State still owns about one-third of the enterprise sector, and large minority stakes (40 percent on average) in some 1,100 privatized enterprises, for three reasons. First, a group of 10 very large enterprises operating in the infrastructure and energy sectors was excluded, by design, from the initial scope of privatization policies 29. Instead of falling under the Transformation Law, these enterprises were commercialized and came under direct State ownership, with the designation of 'public enterprises'. Second, the Transformation Law's emphasis on insider buy-outs implied the privatization of the smaller, rather than larger, enterprises. Privatized enterprises are significantly smaller than those remaining in State hands, by equity, sales or employment measures, and the economic weight of the 270 companies in which the State retains majority ownership is quite significant: 40 percent of the 'privatizeable equity', and 30 percent of employment (Table 2.1). Third, the privatization of these larger enterprises slowed down after insiders had exhausted their priority rights, because the 'second- round' privatization methods, tenders or auctions carried out through the Zagreb Stock Exchange, did not prove very effective30 .

2.8 On a more positive note, the authorities allowed, starting in early 1994, holders of 'frozen' foreign exchange deposits3' to use them towards the purchase of enterprise shares. This

29 These enterprises account for about 14 percent of sales and employment in the enterprise sector and include, in particular: INA, a large oil conglomerate and the largest Croatian enterprise; the electricity company (HEP); the railways company (HZ); and the postal and telecommunication company (HPT). Among the reasons for delaying the privatization of these enterprises were their large size, and complex structures; the existence of natural monopolies, requiring adequate regulation prior to privatization; the damages suffered by many of them during the 1991 war, and the then unsettled status of Croatia's foreign debt, much of which is owed by these enterprises. 30 There were, in turn, several reasons for this slowdown. First, tenders and auctions have been hampered by the insistence on high floor prices based on improper valuation methods, and by the underdevelopment of Croatia's capital markets. Second, no efforts have been made to break up the largest of the remaining enterprises into smaller, self contained units that might be more easily privatized. This particularly hampered, for example, the privatization of the vertically-integrated agriculture enterprises, the 'agrokombinats'. Third, the operating procedures and capabilities of the Government agency in charge of sales (the Croatian Privatization Fund, CPF) were insufficient to deal with the residual privatization cases. Fourth, although there are indications of increasing interest from foreign investors, little has been done so far to meet this demand and promote Croatia abroad. Finally, the alleged lack of 'transparency' of some of the large transactions has generated significant criticism of privatization in Croatia. It also did little to improve the perception of the Croatian privatization program abroad. 31 As in many socialist economies, foreign exchange deposits of banks had to be surrendered, before independence, to the Central Bank (National Bank of Yugoslavia) for domestic money. Devaluations resulted in an asset-liability mismatch. When a run on foreign exchange deposits started in 1991, Croatia 'froze' them. Banks were provided with foreign exchange-denominated counterpart claims on the State, repayable in 10 years. Foreign exchange deposits will become available to their holders as and when these claims are repaid. 26

scheme was very successful because it helped circumvent price-setting rigidities: a secondary market for foreign exchange deposits developed, between depositors facing liquidity problems and individuals or entities willing to purchase enterprise shares at lower than official prices. These swaps contributed to a large extent to the results of 'second-stage' privatization to date (about US$1,300 million out of total sales of US$1,500 million), and reduced public debt commensurately 32.

Table 2.1: Selected Enterprise Indicators by Ownership Status (end-1995)

Numbers Distribution of Average by Enterprise % of Capital Held by Employment Sales Sales ($mn) Employees Equity Shaehoiders Prievte Small (Sm) Seator share

Not covered by the 814 24,0%, 18.5% 508 216E n.a 0 0% 0 Transforrnation Law'

10 large utilities 10 13.9% 14.2% 503.3 10,199 1,344.0 0% 0% Other (local utilities, etc) 804 10.1% 4.3% 5.0 91 n.a. 0.0 0% 0% Covered by the 2,956 52 1% 41.4% 11 12E n.a 213 n.a rLa Trans§formaton Law*

Still publicly-owned 672 20.2% 13.1% 6.9 220 n.a. o1w non commercialized 402 5.1% 3.3% 2.9 92 n.a. 0% 0% olw commercialized 270 15.2% 9.8% 12.9 411 23.5 349.9 20% 16% Privatized 2,284 31.9% 28.3% 4.4 102 5.0 213.2 65% 50% olw majority privatized 1,142 16.0% 14.2% 4.4 102 .5 340.9 61% 44% olw fully privatized 1,145 20.2% 17.7% 5.5 129 1.4 85.9 94% 87% Pnivately established 55,850 23,9% 40 1% 0.3 3 n.a. n.a 100% 10 Grand Total 59,620 100,0% 100.0% 520 348 n.a n,a n,a n.a * Enterpises earmarked for mandatory commercialization, and privatization Source: Croatian Privatization Fund, and World Bank estimates

2.9 Lack of owner-led restructuring. The State as an owner has done little to improve the performance of the enterprises remaining under its control. In the case of enterprises covered by the Transformation Law, a key reason for this lack of involvement has been that the shares unsold in the 'insider buyout' round were divided among two holders: the CPF (two-thirds), and the public pay-as-you-go pension scheme (one-third). The Pension Fund, pending a decision as to for which purposes to use its equity portfolio (see Chapter VI, pension reform), has been acting as a passive partner. The CPF has a privatization, rather than a management or restructuring, mandate and is not equipped to tackle the many enterprises left in its portfolio. Although it has appointed representatives on corporate supervisory boards, the evidence suggests a virtual lack of monitoring, much less supervision of operations or inducements to restructure.

32 Much more questionable has been the practice of mandatory 'swaps' used in several occasions by the State to offset public liabilities. This 'privatization technique' was first used to settle part of the arrears of the public health insurance system to its suppliers in 1993. In 1995, plans were made to cut back nominal wages of civil servants in exchange for State-held enterprise shares but were rejected by Parliament. The same year, however, the Government had Parliament enact a Law under which the creditors of insolvent enterprises can be forced to accept these, or other, enterprises' shares in lieu of loan repayment. More recently, the Government also proceeded to 'improve' the financial condition of insolvent banks by taking over some of their bad share portfolio (itself often the result of prior swaps for non- performing loans) in exchange for CPF-held shares. Such schemes have done little to improve the governance of publicly-owned enterprises, nor to improve public perceptions of privatization policies, including among foreign investors. They may only have contributed to weaken the payment record and, ultimately the creditworthiness of the State. 27

The situation is hardly better for the 10 public enterprises. The Government established, in 1993, a small unit dedicated to the supervision of public enterprises, the Office for Restructuring and Economics of State-owned Enterprises (ORESE). ORESE's achievements, a closer monitoring of the public enterprises' performance, and the alignment of their corporate structures with that of other joint-stock companies 33, were not negligible but fell short of effectively controlling and guiding management decisions.

2.10 These institutional weaknesses have been compounded by the size and complexity of the enterprises left in State hands and the clout of their managers. In the larger public enterprises, INA, and to a lesser extent, the electricity and railways companies, the combination of intricate corporate structures and of technically complex lines of business makes effective monitoring a challenging endeavor. But many other businesses were also organized as large conglomerates, for instance in the tourism, agriculture, and heavy engineering sectors, where one single enterprise typically owns clusters of 10-20 units. One frequent result, in addition to weakened competition, is extensive cross-subsidization within group structures and soft budget constraints on loss-making units. In the context of privatization, such corporate structures may also give rise to decapitalization by dishonest managers or, at best, to a loss of revenue for the central budget.

Table 2.2: Trends in the Labor Market

In thousand Population 20-59, 20-55 2,462 2,452 2,453 2,459 2,466 2,468 6 Recorded Employment 1,956 1,826 1,657 1,645 1,591 1,542 -414 Government 341 409 395 418 401 475 135 defense and interior 75 159 161 184 167 238 163 other 266 250 234 234 235 237 -28 Non-Government 1,241 1,051 904 832 826 750 -491 - Industry 561 462 398 385 368 348 -213 - Other 1,054 955 863 842 822 719 -335 Recorded Unemployment 196 283 261 243 248 249 54

Changes in Labor Demand (129) (170) (12) (54) (49) (414) Changes in Labor Supply (42) (192) (29) (49) (48) (360) - New Entrants (net*) 38 36 35 33 33 175 - Retirements (76) (49) (44) (34) (20) (224) - Other (displaced, left the country, withdrew from (4) (179) (20) (48) (60) (311) labor force) Increase in Unemployment 88 (22) (18) 4 2 54

In % of Population 20-59, 20-55 active 87.4% 86.0% 78.2% 76.8% 74.6% 72.6% employed 79.4% 74.5% 67.5% 66.9% 64.5% 62.5% unemployed 7.9% 11.6% 10.6% 9.9% 10.0% 10.1% Unemployment as a% of active 9.1% 13.4% 13.6% 12.9% 13.5% 13.9% Source: CBS and World Bank estimates

33 In 1993-94, the Parliament adopted a set of laws on public enterprises, that ORESE was instrumental in preparing. As a result of these laws: (i) INA was corporatized in 1993; the Government was authorized to sell up to 25 percent of its equity without further Parliamentary approval; (ii) the Railways company was corporatized, and responsibility for infrastructure, as opposed to operation, was transferred to the Government; also, the concession of some transports services to private operators, and the privatization of non-core activities of the railways company, has become possible; (iii) the electricity company was commercialized, and the State authorized to sell up to 25 percent of the shares without further Parliamentary approval; the entry of new private sector operators in the generation and distribution of electricity was also authorized. Finally, a draft Law separating postal services (remaining State-owned) from telecommunications (to be privatized) has been prepared and submitted to Parliament. 28

2.11 The State's conflicting objectives. Not only is the State ill-equipped to force the restructuring of its enterprises but it has, more often than not, delayed it for fear of increasing unemployment levels in Croatia. Government policy, not just the rigid labor legislation of former Yugoslavia -- despite its obvious flaws -- has 'discouraged' enterprises from adjusting their labor force as much as was needed. In 1990-91, under the structural reforms promoted by the last Government of former Yugoslavia, led by Mr. Markovic, enterprises were able to shed redundant labor34 . Registered unemployment increased rapidly during that period, to 13 percent of the workforce (i.e., close to its current level of 14.8 percent, see Appendix, Table 2.2). By contrast, the unemployment rate remained stable over the 1992-96 period, suggesting that enterprises were, by and large, 'allowed' to shed labor only to the extent that open unemployment would not increase significantly (Table 2.2). However significant, the reduction of employment levels since 1991 appears to have been driven by the possibility of absorbing redundant workers elsewhere, rather than by what was economically desirable. The 'absorption' channels have mainly been: enrollments in the army; early retirements; and withdrawals from the workforce, particularly as a result of the war in 1991-92. The experience of the past suggests that the adoption of a new Labor Law in 1995 was necessary35 but will not by itself lead public enterprises to reduce their workforce to the levels necessary for restructuring.

The Incentive System: Priceand Trade Distortions

2.12 As already mentioned, Croatia was spared the worst features of central planning, particularly administrative price-setting, and State control over trade flows. Although the general incentive framework was comparable to that of market economies for decades, a number of distortionary policies shielded selected sectors or subsectors from competition,, the most noticeable example being agriculture.

2.13 In non-agriculture activities, prices are now free, with the exception of public utilities, and the trade regime is generally liberal 6 . Despite its general openness, Croatia's trade regime has significantly contributed to shielding inefficient sectors/enterprises from competition. Typically, higher import duties apply to finished products, largely present in (Croatia's industries, implying higher effective protection rates than nominal rates suggest. In addition, quantitative restrictions continue to protect some 150 products, although their number has been reduced from 850 in 1994. Finally, Croatia maintains, particularly in the agriculture sector, specific duties that considerably increase the effective rate of protection, and contribute to a lack of transparency in the trade regime. High protection is pervasive in the agriculture sector, as discussed below, but also shields from competition a number of the worst-performing industrial sectors/enterprises, such as the refinery and the fertilizer industries (both loss-making subsidiaries of INA), or the paper, textiles, and iron and steel industries.

34 In particular by undergoing a bankruptcy procedure and re-hiring fewer staff under a newly-licensed company. The new Law on labor relations of 1995 introduces, among other important provisions that make it comparable to market economy legislation, the concept of economic redundancy. 36 As of July 1996, import tariff rates range between 5-25 percent, plus a temporary surcharge of 10 percent also applied across-the-board to indirect taxes. Although no aggregate measure of protection levels in Croatia is available, a very crude indication of protection can be derived from the ratio of import duties to final imports (net of temporary imports for processing, which are exempt from import duties), which stood at 14-15 percent in 1995. 29

2.14 Agriculture, however, is the main exception to the otherwise relatively undistorted incentive system in Croatia. Protection levels are very high. For basic commodities, the weighted average nominal, and effective, protection rates were estimated at 48% and 58%, respectively, in 1995. Overall, these levels decreased during 1993-95, but they increased for basic importables, reaching 84% in 1995, in effective protection terms. Moreover, some of these commodities (wheat, oilseeds, sugar beet, tobacco and milk) are protected by import quotas or variable levies, that support a system of floor prices. Floor prices are enforced by processors purchasing at or above the official price and, for wheat, by State purchases. In the case of industrial crops and milk production, the floor price is topped up by an incentive premium. The level of protection is even higher for processed products, whose production is concentrated in the agrokombinats: the weighted average nominal, and effective, protection rates, were estimated at 92% and 904%, respectively. Here also, protection rates were higher for importables, reaching 1,615% in 1995.

2.15 Trade distortions also affect key production inputs, leading to higher costs for domestic producers which are, in turn, partially offset by a system of direct subsidies. Fertilizers, which typically account for 20-45 percent of production costs of major commodities, are subject to tight import quotas. These restrictions serve to maintain the domestic price of fertilizers 25 percent above parity prices, and maintain the monopsony of a loss-making subsidiary of INA. Similarly, the price of animal feed, maize and protein meals, are maintained 35-70 percent above international prices, through variable levies. Most of the animal feed processors are agrokombinats, while most livestock producers are small-scale private farmers. Finally, a combination of high import tariffs and tight import quotas results in high domestic prices on seeds. These restrictions support a high-cost domestic seed industry, and prevent farmers from accessing improved varieties of seeds.

2.16 Trade and price protection have hampered efficient resource allocation, and been translated into unnecessary costs, which have been borne by Croatian consumers and, to a lesser extent, taxpayers. Direct budget subsidies are relatively modest by international standards, at I percent of GDP in 199537. But total transfers to producers, including price support, are considerably higher, approximately 9.5 percent of GDP38 . The difference between the implicit and the explicit (budgetary) subsidy has been borne by Croatian consumers in the form of higher prices.

Soft Budget Constraints

Legal and InstitutionalFramework

2.17 One key way to bring about efficiency and market-based behavior in enterprises is to strictly enforce financial discipline. In mature market economies, bankruptcy is the central mechanism that is used for helping financially distressed companies weather difficult periods and recover, or exit the market place. Croatia recently replaced the ineffective bankruptcy legislation

This does not include, however, the -- unavailable -- costs of price support which are borne by the State Directorate of Commodity Reserves and funded directly by Parliament. 38 Six percent of GDP for primary agriculture, and 3.5 percent of GDP for agroprocessing. 30

inherited from former Yugoslavia 39, but the institution and skills basis required to enforce the new legislation is still weak 40 . Furthermore, a critical condition for exit mechanisms to function is that creditors or debtors have the incentive to use them. In Croatia, this incentive had been seriously weakened by Government attempts at bailing out troubled enterprises, and by the collusive relationship existing until very recently between troubled enterprises and a key group of creditors, the banks.

Government Bail-outs

2.18 In addition to lack of experience, the credibility of bankruptcy as an exit mechanism has been seriously weakened by several Government attempts to resolve enterprise crises, akin to outright bail-outs. The first was the so-called 'big bonds' scheme, whereby the Government issued, in 1991, US$1 billion worth of its bonds, or 6-7 percent of GDP, to public enterprises in financial difficulty. Enterprises passed on these bonds to banks in lieu of loan repayment. The condition required in exchange for the bonds, the implementation of restructuring plans, was never implemented, partly due to Croatia's independence and the war.

2.19 More recently, in late 1995, Croatia also passed the Law on the Rehabilitation of Selected Enterprises (LRSE), relating to the insolvency of the large debt-ridden public enterprises 41 . Whereas the LRSE requires the debtor company and the line ministry to put together a 'restructuring plan', it essentially spells out the conditions whereby enterprises will be relieved from their debt (i.e., a mandatory debt-equity swap in which creditors, including the banks, will become the 'new owners' of the debtor company or receive CPF-held shares in other companies). As a result, the LRSE suffers from the same criticisms as the 'big bonds' scheme, namely, that debtor-led rehabilitation plans are rarely successful and that the law provides the debtor with free reign to delay while loss-making continues. The other major danger of the law is that it denies creditors' rights, including apparently those of secured and foreign creditors, and can deal a serious blow to the confidence of investors and lenders in the security of financial transitions.

The former legislation was fairly inflexible and only foresaw the possibility of voluntary (in case of solvency) or court-led (in case of insolvency) liquidation of an enterprise's assets, as opposed to court- supervised restructuring and protection from creditors. For this reason, the law was not well-used in practice, except as a labor-shedding device by companies which could not declare redundancies due to a highly protective labor law. Companies would declare bankruptcy, end the juridical status of the company, let workers go, reconstitute the company as another legal entity and then rehire only the workers the company needed. Judicial experience in Croatia in insolvency is thus highly limited to this peculiar application of bankruptcy to labor issues.

40 The new bankruptcy Law was adopted by Parliament in April 1996, and came into force in 1997. Based on the new German legislation, the new Law is much more flexible than the former SFRY law, and introduces, in particular, court-supervised reorganization of enterprises. It is, however, fairly sophisticated and uses commercial concepts and procedures unfamiliar to most of the judiciary. The proposed law also requires, for its application, the development of skills, such as certified trustees, which do not currently exist in Croatia. In order to apply it effectively, the new legislation will require a considerable transfer and build-up of market- based skills both to the judiciary and the various professions associated with assisting financially distressed companies. 41 The LRSE uses broad and unstated criteria to define the eligible companies ('companies of importance to the Republic with respect to its defense or strategic needs, or that are indispensable to the functioning of other companies, and the life and work of citizens'). 31

Bank-EnterpriseNexus

2.20 The other key factor that undermined financial discipline in Croatia has been the widespread collusion between enterprises and banks. Like in most transition countries, banks have preferred to extend new loans, or roll over old ones, to their troubled customers in order to keep them afloat, rather than let them go bankrupt and have to recognize their own losses, or insolvency. Unlike in most other transition countries, however, it was all the more difficult for banks to enforce financial discipline because they were themselves owned by their customers, a peculiarity of the former Yugoslav system. Most banks dating from pre-independence, which still dominate the banking system 42, were controlled until recently by enterprises which sat on their supervisory and management boards. This ownership structure has led to widespread related-party lending, non-performing portfolios, and insolvency, in four banks which account for half of the banking system's assets. A review of the 24 enterprises that recorded the largest losses in 1994-95 indicates that practically all of them are shareholders of one or several of these banks, and often belong to the group of the 10 largest shareholders. Entire loss-making sectors, such as the shipyards, were well-known for their ownership links with the banking sector.

Supply Response Strategy

2.21 All too clearly, the perfornance of Croatian enterprises has been impaired by the lack of profit-oriented owners, including the State, and by a tradition of weak financial discipline. A two- pronged strategy is therefore necessary to address these issues:

U As a matter of priority, inefficient enterprises should be forced to restructure, or exit the market. This function is normally ensured, in market economies, by creditors, particularly banks, and the judicial system and this process should be strengthened. In the meantime, there may be a justification for 'jump-starting' the restructuring process through Government intervention, as is currently being undertaken by the Croatian authorities. But this effort must be time-bound to allow market forces to evolve and strengthen in the near future. In parallel, enterprise privatization should be pursued actively, but with much more of an emphasis than in the past on achieving results in terms of governance. This enterprise reform agenda is discussed in more detail in Chapter III.

42 Only one large bank (Zagrebacka Banka) was spared the worst effects of this system because its shareholders were a diversified group of small enterprises, none of them important enough (their stakes were no more than 2 percent of total capital) to skew lending decisions. This bank is now majority privately owned. 32

0 The financial system must be able to fulfill the key functions that it performs in market economies: foster savings, and allocate them, at the least cost, to the most efficient enterprises; exercise financial discipline; and facilitate the evolution of corporate ownership structures, when needed. While the resolution of the current banking crisis would go a long way towards achieving these goals, more remains to be done in order to foster efficiency and competition in the banking system: establish a level playing field; alleviate the constraints of financial repression; and ensure the orderly exit of those institutions which cannot withstand a decrease in intermediation margins. In addition, capital markets should be developed, as a way to intensify competition on banks, and contribute to corporate governance. These policies are discussed in Chapter IV. CHAPTER THREE

HOW TO IMPROVE ENTERPRISE EFFICIENCY?

3.1 In the short-term, forcing inefficient enterprises to restructure, or exit the market, may be one of the most important priorities faced by Croatia. The required decisions may be difficult, and their social impact should be cushioned by an appropriate safety net (Section 1). But they will pay for themselves: the reduction of corporate losses means higher domestic savings, and will result in lower interest rates, improved credit allocation, and higher productivity and growth. Once the current enterprise crisis is resolved, efficiency should be maximized by ensuring that enterprises operate under a liberalized trade regime (Section 2), that they are properly governed, which implies the completion of the privatization agenda (Section 3), and that they can interact with a more effective financial intermediation system. This issue is discussed in depth in Chapter IV.

SECTION 1 - RESOLVING THE ENTERPRISE CRISIS

Downsizing and Restructuring State Enterprises

3.2 As discussed in Chapter II, the close ownership and financial links between troubled State enterprises, and problem banks, imply a joint resolution of the two issues, which the Croatian authorities have started to implement43 . They have developed a Box 3.1 The Bank Rehabilitation Legislation legal and institutional framework in cntrst o pat plic IThe bank rehabilitation legislation of 1994 includes the taw on Bank which, Rehabilitation and Restructuring' and the'Law on the State Agency for measures such as the big bonds Savings insurance Deposits and Bank Rehabilitation'. The State scheme or the Law on the Agency established by the latter piece of legislation is more commonly Rehabilitation of Selected Enterprises, referred to as the 'Bank Rehabilitation Agency' (BRA). The legislation provides adequate tools to resolve the provides for mandatory or %oluntary bank rehabilitation (banks have lost over, or less than, 50 percent of their share capital, after proper enterprise and banking crisis in a provisioning of their asset portfolio. respectively). Bank rehabilitation credible and long-lasting way. Indeed, includes essentially thee steps: (i1 the bank's share capital is reduced to the Bank Rehabilitation Agency reflect actual losses, (ii) selected non-performing assets are transferred (BRA) established by the bank from the banks balance sheets to the BRA. for their resolution. (O) the legislation of 1994 (Box functions of the shareholdees assembl), and the supervisory and rehabilitation management boards. are suspended and transferred to the BRA, until 3.1) should not only resolve the issue the bank Ls recapitalized by the BRA. The BRA may subsequently of the troubled banks' ownership, and divest its shares in rehabilitated banks. The BRA is managed by a financial condition, as will be Duector reporting to a Board. chaired b) the Prime Minister, and discussed in Chapter IV, but act as a including high-level officials from the Central Bank. and the 'restructuring agent' capable of Gowem catalyzing enterprises restructuring, which is this Section's topic.

3.3 Although the enabling legislation was adopted almost three years ago, progress has been slow, reflecting both the lack of relevant experience in Croatia, and strong vested interests. On the institutional front, it was not until late 1995 that the BRA became ready to start operating in earnest. Similarly, delays in intervening in troubled banks held up action on the enterprise front

43 Banking sector issues will be primarily discussed in Chapter IV. They are mentioned in this Chapter, however, to the extent this is necessary to understand the enterprise restructuring framework. 34 until recently: only the least troubled, and smallest, of the four problem banks, Slavonska Banka, was restructured in 1995; the rehabilitation of two larger-size, regional banks, Splitska Banka and Rijecka Banka, started in early 1996; and it was not until December 1996 that the decision to rehabilitate the largest problem bank, Privredna Banka Zagreb (PBZ) was made. Nevertheless, these decisions were important: perhaps for the first time in Croatia, they sent to enterprises a strong signal of return to financial discipline, and they virtually eliminated their ownership in the troubled banks44. But they mark only the beginning of the process: Croatia has yet to move ahead with enterprise restructuring, including its social consequences.

3.4 The authorities should now implement without further delay the Box 3.2: INA, A Restructuring Case Study provisions of the rehabilitation legislation, which call for the worst The case of INA illustrates the challenges of enterprise restructuring in assets of the banks under rehabilitation Croatia The INA group is the largest Croatian enterprise group, w ah salesof about USS2 billion, and a workforceof 30,000 O%er the years, to be transferred to, and resolved by, it er its actiities well beyond its core oil and gas business, into the BRA. This transfer is critical for at activities ranging from femlizers to tourism. It posted losses for the first least two reasons. First, it is likely the time in 1995 (US$230 million equivalent) but has not been servicing its only way to force the downsizing of large foreign debt (about US$1 billion) since Croatia's independence the l rBecause of distortions in transfer pncing between units, some companies larger loss-makers. This task is in the group performec much more poorly than reported. and were in clearly beyond the capacities of the effect cross-subsidized h the better performers Wile some units in the court system, and of banks themselves, group may be turned around after substantial physical resmetrturing, like which should use their limited the Kutina fertlizer complex. others (like refineries) may ha%e less good institutional resources to deal with prospects for financial or economic %iabilitn. A %alueadded analsis for the entire hydrocarbon dhain of the group, also revealed a senous lack of smaller enterprises, and their own transparency, and problms of steady decapialization of some acti ities. restructuring. Second, the presence, on the troubled banks' balance sheets, of fNA has vrtually developed a comprehensive business and restructuring assets involving large and politically plan, with the objective of downsizing and concentrating the group to ius core oil and gas produciions. and disribution acuvities, and opening its sensitive enterprises, such as NA or capital to the pnvate sector. USS500 million wonh of non-core assets the shipyards, would be a major haie been relinquished -.,t the beginning of 1997 to the Go%mrnent- for obstacle to their privatization. subsequent pri%atization, and to oftet the assumption of an equi%alent Whereas the enterprises that should be amount of foreign liabilities. INA must now be allowed by its ow%ner to tackled by BRA need not be many in implement its plan w%ithout dela% In addition to the ditesuture of the vast array of non-energy activities. this should include the partial closure numbers - perhaps 70, they would of the Kutina fertilizer complex, the partial or entire sale of some other account for the larger part of the losses petrochemical units to strategic partners; the closure of one or prefermbly recorded by the enterprise sector. The tv%o refineries: and a dr.-tic reduction of its w%orkforce. transfer of bank assets to the BRA may need to include not only non-performing loans but, because of the particular history of enterprise 'restructuring' in Croatia, bank-held shares in troubled enterprises: most troubled banks have voluntarily converted some of their bad loans into equity; they have, in addition, received shares in lieu of loan payments under the mandatory debt-to-equity swap scheme promoted by the Law on Rehabilitation of Selected Enterprises.

3.5 As the BRA will be performing a central role in bank and enterprise restructuring and privatization, the Government should ensure that it operates under a proper incentive framework. A sunset provision should explicitly limit in time BRA's enterprise restructuring activities to, perhaps, three years. Debtor enterprises should have no access to any bank or inter-enterprise

44 The share capital of Rijecka Banka and Splitska Banka was entirely written off against their losses, thus wiping out previous shareholders. 80 percent of the capital of PBZ was similarly written off. 35 financing, and depend only on BRA to finance current losses. BRA itself should operate under a hard-budget constraint. Its funding requirements should be met out of current operations (i.e., the sale of enterprise assets or collections on problem loans).

3.6 While retaining full operational autonomy, BRA management should be closely monitored, against pre-agreed performance targets. Management should be required to submit a time-bound business plan spelling out, for each of the assets to be resolved, the planned course and timing of action. These plans would provide for either, or a combination of the following options: (i) foreclosure on collateral; (ii) sale of part of the enterprise assets; (iii) bankruptcy procedure and recovery of part of the debt; or (iv) agreement on a business plan involving the downsizing and reorientation of activities, and restructuring of the debtor's indebtedness with all its creditors. To avoid conflicts of interest and stalemate, the Government should also require the CPF to transfer to the BRA its holdings of shares, if any, in the problem enterprises being restructured under BRA leadership. This measure would reinforce BRA's ability to negotiate restructuring plans and/or sell enterprise assets.

Social Safety Net

3.7 If enterprise restructuring is to take place in a socially acceptable way, it is critical that Croatia design carefully, and fund adequately, comprehensive labor adjustment programs, combining 'active' and 'passive' policies. Active policies should minimize the duration of frictional unemployment, and enable workers to resume their contribution to economic growth as soon as possible. Passive policies should provide temporary income support to those unemployed, and avoid the permanent transfer of redundant workers into public payroll, a temptation that Croatia did not always avoid in the past. Both policies have been implemented in Croatia, by the Unemployment Fund45 and the social assistance administration, 46 but on too limited a scale. Indeed, spending on labor policies -- 0.5 to 0.6 percent of GDP since 1992, see Table 3-1 -- appear to be insufficient, a feature that may have contributed to Croatia's reluctance to let open unemployment develop beyond certain limits. If temporary unemployment is to be accepted as a corollary of labor market adjustment, the Unemployment Fund's resources will need to be increased commensurably with higher numbers of unemployed: judging by the experience of Poland, Slovenia or Hungary, spending anywhere between 2 and 3 percent of GDP on unemployment policies for a few years may be unavoidable.

3.8 A significant part of these resources will have to be devoted to spending on active labor policies, which declined to virtually zero in 1996 (Table 3-1). In addition, if the challenge of unemployment is to be met, the design of active policies will have to be revisited. The desirable improvements include: (i) de-emphasizing the policy of subsidizing for job creations; job subsidies have been shown elsewhere to contribute in a limited way to the net and/or permanent creation of jobs, but, rather, to lead to substitution effects; (ii) create specialized services to assist enterprises, at an early stage, in the process of mass layoffs; these services should be

An extrabudgetary fund, the Employment Fund is financed through a 1.9 percent payroll tax, yielding approximately .8 percent of GDP. The Fund's resources are spent on three programs: active policies; unemployment benefits proper; and payment of pension and health contributions on behalf of unemployed who have run out of their rights to cash benefits (Table 3-1). 46 Social assistance is delivered through 113 social welfare centers (1,900 employees) under the Ministry of Labor and Social Affairs. It absorbs about 1 percent of GDP, of which .3 percent for a variety of means- tested cash and in-kind benefits. 36 decentralized, particularly in areas likely to suffer most from unemployment; have access to an improved set of instruments, as discussed below; and operate in close coordination with local players such as employers, unions, and other members of local communities; (iii) develop training and retraining actions; like in many transition economies, market economy skills tend to be in high demand and short supply; the number of vacancies has been consistently high over the past few years, about 50-60 percent of registered unemployed; (iv) expand the instruments of active policies, for instance offer the option of 'capitalizing' unemployment benefits into lump sums or soft loans for business startups, and provide support services to emerging private enterprises (e.g., enterprise 'incubators' or other business services centers); temporary public work programs should also be considered in Croatia, considering the large infrastructure and reconstruction needs 47; (v) finally, increase the human resources allocated to active policies; with about 300 clients per staff, the Employment Fund is clearly under-equipped when compared to OECD countries that have emphasized active policies, where each staff typically deals with 100 customers or less.

Table 3.1: Expenditure of the Unemployment Fund

Unemployment Benefits 0.21 0.88 0.24 0.08 0.16 0.28 0.34 Active Policies 0.01 0.00 0.07 0.13 0.19 0.14 0.04 Transfers to Health and Pension Funds 0.10 0.52 0.21 0.14 0.13 0.15 0.13 Operating expenses 0.10 0.05 0.02 0.00 0.03 0.04 0.03 Transfer to State Budget 0.24 Total 0.42 1.45 0.53 0.36 0.50 0.61 0.78

SECTION 2 - TRADE LIBERALIZATION

3.9 Beyond short-term enterprise restructuring, efficient resource allocation needs to be ensured through trade policies that do not protect unviable enterprises, or activities. Fuller trade liberalization would also facilitate the process of accession to the World Trade Organization, currently underway (see Box 3.3). The high level of current protection in some areas, however, and the inability of inefficient producers to shoulder increased competition in a short time frame, will necessitate a phased approach, in tandem with progress on the restructuring front.

3.10 In the short-term, policy measures should focus on the dismantling and tarification of remaining quantitative restrictions and other non-tariff barriers. Successive reforms since 1993, and the latest Customs Tariff of July 1996, have already brought about considerable improvements. In agriculture, for example, the number of quotas was reduced from 215 to some 50 items, and a system of variable levies was eliminated in 1996. The latter, however, was replaced by a combination of ad-valorem duties and quantity-based tariffs, which can not only be modified at the discretion of the Ministry of Agriculture, but be complemented by seasonal tariffs. Quotas, specific and seasonal tariffs considerably reduce the transparency of the trade regime, and should be replaced immediately with their tariff equivalent.

The difficulty with such programs, however, is that they may perpetuate public funding of what may be, or become, non productive work. They should be designed as temporary, and combined with job search requirements and, to the extend possible, training or retraining. 37

3.11 Tarification should result in ad valorem rates much higher than the current ones, and close to current effective protection levels: in the agriculture, these rates could be around 50% for commodities, and 100% for processed products. These rates of protection should be reduced over a period of three to five years, to more modest and uniform levels, say 25-20% at most. Consistent with art. 19 of the GATT, Croatia could prevent 'abnormal' injuries to domestic producers by adopting a system of temporary safeguards, that would be price-based, time-bound, and transparent.

Box 3.3: Croatia's Accession to the WTO The Republic of Croatia has begun the process of accession to the World Trade Organization (WTO). A Working Part was established in October 1993. Following the submission of a 'Memorandum on Foreign Trade Regime' in June 1994. replies to the questions raised by members on Croatia's trade regime were circulated in August 1995. The first meeting of the Working Party was held in April 1996. The process of fact-finding and bilateral negotiations is expected to i be extended through 1997. Accession to the WTO is in Croatia's economic interest. It will provide an opportunity to lock-in sound economic policies, and a framewtork for restructuring trade pohcy and regulations. WTO membership will provide Croatia a basis to resist future domestic pressures for increased protection and backsliding. It will open new markets to products and services in which Croatia has a comparative ad%antage. As a small country. Croatia does not have bargaining power to negotiate trade concessions effectively on a bilateral basis. WTO membership will otTer automatic most-favored nation treatment among all WTO members. It "ill also offer protection to Croatia's exporters agams undertakings by other countries to restrain access to their markets.

SECTION 3 - COMPLETING THE PRIVATIZATION AGENDA

3.12 The Government intends to address the shortcomings of past privatization policies through the provisions of a new Privatization Law (March 1, 1996). This law envisions the complete divestiture of former socially-owned enterprises through several measures, including: a voucher privatization scheme; more flexible price-setting mechanisms; and a more effective decision-making process. It also mandates that 25 percent of the shares of public enterprises, when privatized, be earmarked for pension reform purposes, to facilitate the transition to a multi- pillar pension system (see Chapter VI). As it stands, the new legislation is a very useful and versatile tool that could effectively boost privatization in Croatia. This section argues, however, that much remains to be done in order to implement privatization policies that would effectively foster enterprise governance, and competition. It offers specific suggestions in the following areas: mass privatization; the 'mapping' of privatization; and the specific issues raised by the privatization of public enterprises.

Voucher Privatization

3.13 The new voucher privatization scheme envisions the free distribution of a significant part of the remaining CPF share portfolio to three categories of the adult population that are considered to have legitimate claims on the society: refugees and persons displaced by the war; disabled war veterans and their families, as well as those of missing persons; and former political prisoners48 .

48 The eligible population was originally estimated at around 350,000 persons which would receive vouchers worth about US$4,500 on average but, at the time registration started, was received to 230-250,000 38

3.14 Voucher privatization has potential advantages. As seen for example in the Czech Republic, it may succeed in transferring rapidly into private hands large numbers of enterprises, and contribute to the development of capital markets. It is also prone to specific risks: first, enterprise governance may not be particularly enhanced by the dispersion of ownership inherent to mass privatization; second, capital markets development may suffer, rather than benefit, for instance if large-scale sales of shares lead to a collapse in market prices; finally, voucher privatization is by design vulnerable to political considerations, which can result in protracted implementation, as was experienced by Poland.

3.15 In Croatia, these conflicts in objectives are likely to be magnified by the nature of the target population 49, which is likely to be overwhelmingly driven by short-term financial considerations. The risks are therefore significant, and need to be defused through careful design and implementation of the scheme. Three objectives, in particular, should be given high priority: promote indirect, rather than direct, holding of shares (i.e., through investment funds); ensure an adequate match between supply and 'demand'; and enhance shareholder awareness.

PromotingIndirect Shareholding

3.16 Promoting indirect shareholding, through investment funds, can serve several purposes: facilitate the initial allocation of shares (bidding, selection and pricing of shares, portfolio diversification); avoid massive post-distribution sell-offs, and their damaging consequences on prices and market credibility; reinforce enterprise governance; and contribute to the development of a professional capital market. This option is open under the Privatization Law: individuals may exchange their vouchers either directly for enterprise shares, or for shares in investment funds, which will in turn exchange them for enterprise shares. However, if the indirect shareholding route is to be a credible option, and to fully deliver its potential benefits, several other conditions will have to be fulfilled: investment funds must participate to the bidding process at the same time as individuals, not in a second round; and enough time -- say one year -- must be allowed before the bidding, to enable investment funds to emerge. This time period should be used to solve or clarify a number of issues regarding: the role of investment funds in corporate governance; their selection; and their regulation.

3.17 Investment Funds' role in corporate governance. It is commonly accepted that investment funds in transition economies should contribute to corporate governance, including enterprise restructuring, in contrast to the more 'passive' role played by many institutional investors in more mature market economies. This was the model followed, with variations, by Poland, the Czech Republic and Slovakia. For investment funds to play such a role in Croatia, several features need to be built into their design from the outset. First, the current prohibition to hold more than 10 percent of the shares of a single company, established in the Investment Fund Law, should be repealed or significantly relaxed (increased to, say, over 50 percent) for investment funds participating in the voucher privatization program. On the other hand, the concentration rule -- that shares of a single company cannot exceed 10 percent of a fund's total assets -- should be maintained, or not increased significantly, for reasons of elementary portfolio

'actual' participants. The overall 'entitlement', US$1.0 billion, is equivalent to 35% of the nominal value of CPF's residual portfolio, and probably much more in terms of market value. 49 This choice, however, was understandable on equity grounds. It has been argued, for example, that displaced persons were not able to participate, because of the circumstance, in the first round of 'insider buy- out' privatization. 39 diversification. Second, corporate governance, or enterprise restructuring, abilities should be explicitly stated as one of the selection/licensing criteria for PIFs (see next paragraph). Third, clear rules against conflict of interest should be established. Finally, the investment funds' compensation structure should include adequate incentives, such as success fees based on improved enterprise profitability, or on capital gains made at the time of resale of shares.

3.18 Selection. Successful investment fund participation to voucher privatization implies that they be limited in numbers, and meet high professional standards. Given the relatively small size of Croatia's mass privatization program (US$1.0 billion), the limitation of the number of funds appears necessary if they are to build up a portfolio of sufficient quality and size, and shoulder their management costs. However, prospects of adequate profitability are a necessary, but not sufficient, condition to ensure a high-quality selection of investment funds. The selection of investment funds should be based on published criteria, allowing foreign participation, and setting high requirements in terms of: prior record in the asset management, or other related, areas; professional and ethical standards of staff; and commitment of some of the fund manager's own funds which would be also invested in the managed portfolio. Finally, the dual purpose of limiting the number of funds, and ensuring managerial quality, would be best pursued by issuing licenses based on the results of a one-time tender process.

3.19 Regulation. The framework provided by the Securities Law, and the Investment Funds Law is, typically, general and needs to be considerably detailed through regulations. An important matter to clarify is that investment funds should clearly be of a 'closed-end', as opposed to 'open-end' nature50 . This implies that their shares will not be redeemable, as this could force investment funds to 'firesale' part of their portfolio at a loss for their investors. They could, however, be tradable on the Stock Exchange, at a price reflecting supply and demand for investment fund shares, which may significantly deviate from the value of their underlying portfolio. Trading would be facilitated by registering investment fund shares on a book-entry, as opposed to bearer's, basis. Other areas such as minimum capital requirements, prudential investment limits, disclosure requirements, management credentials, also need to be carefully regulated. Finally, the regulation of investment funds also requires that a credible watchdog be in place. Normally, most of these functions should be performed by the Securities and Exchange Commission, which is only being established in Croatia. Drafts of a law on Privatization Investment Funds and fund licensing regulations were prepared by this summer jointly by the Securities and Exchange Commission and the Ministry of Privatization to address all these issues in a comprehensive manner.

MatchingSupply and Demand

3.20 The Government should adhere to its intention to use a multi-round bidding process, as was successfully experienced in other mass privatization programs. As mentioned, the bidding should not take place too early in order to allow the regulation, and the emergence, of investment funds. Although the bidding process will by definition establish the value of shares, it may do so at the cost of significant deviations between the companies' market and book value. To avoid later frustrations, the Government should ensure that the pool of assets available for mass

50 The lack of liquidity on the secondary market and the fact that investment funds will be mostly invested in shares rather than more liquid assets, such as fixed-interest securities or bank deposits, initially leaves no other option. 40 privatization broadly matches entitlements, based on realistic evaluations 51. This will also be a critical factor to attract high-quality investment fund managers.

Shareholder'sAwareness

3.21 As in most transition economies, the population's initial awareness of shareholders rights was quite limited. As discussed, this allowed some managers, or large shareholders, of privatized enterprises to exercise their control by frustrating the rights of minority shareholders. The Ministry of Privatization has strove to educate the population through a public awareness campaign. Reaching for its own resolution of such problems, there is also a Union of Shareholders' Associations, and, at last count, over 60 shareholders' associations established on a company-by-company basis. Additional efforts are needed to ensure the success of the voucher privatization program, focusing among other things on the role that the investment funds will play, and educating the vouchers holders on the risks involved when they elect to directly exchange their vouchers for shares of individual enterprises.

'Mapping' Privatization

3.22 While an adequate supply of shares is essential for the credibility and success of the mass privatization program, there are other competing demands for 'good' assets. With improved economic and political prospects, strategic investors -- particularly foreign ones -- could be offered large stakes in companies that could particularly benefit from their management, marketing and technological skills, as well as from fresh equity injections. The successful public offering of the 'Pliva' pharmaceutical company52 abroad may also be repeated with a few selected enterprises. All in all, significant or controlling stakes in some 50 large- and medium-sized enterprises could be set aside for such transactions.

3.23 With the exception of these set-asides, the entire balance of the CPF portfolio should be offered in the mass privatization program during the second half of 1997, and should essentially be cleared by the bidding process. Residual stakes, if any, should then be sold through the traditional CPF procedures, against cash and at market clearing prices.

Public Enterprises and Large Entities

3.24 As discussed earlier, the large size of public enterprises, and of some former socially- owned enterprises, is an obstacle to their effective control, to competition, and possibly to their privatization. Croatia has made progress towards developing anti-trust policies, adopting in June 1995 the Law on the Protection of Market Competition and Monopolies. However, no regulatory body has been established and building the skills and institutional base will take time. A much faster way of promoting competition, given that most potentially monopolistic enterprises are still in State hands, would have been to build in competition objectives in the design of privatization policies. Breaking up INA, tourism holding companies, or agriculture kombinats in smaller

51 Anecdotal evidence, as well as the low returns on the CPF and the pension funds' portfolios -- 2.5 percent on book values -- suggest that the current valuation of many enterprises is considerably overstated.

52 In April 1996, with the assistance of an international investment bank, a domestic bank, and EBRD, the CPF successfully sold 27% of the shares (US$140 million) of Pliva through a Global Offering. The offering was divided in two equal tranches, international (through GDRs) and domestic. The GDR offering was substantially oversubscribed. 41 entities would not only ensure more of a level playing field in the near future, but greatly facilitate the privatization of these entities.

3.25 Regarding former socially-owned enterprises, the new privatization law has clarified and simplified the procedures 53 whereby enterprises can be split according to the Company Law procedures. It is now up to the CPF to apply these procedures without delay to the large entities remaining in its portfolio, particularly hotel chains and agrokombinats. The CPF can for example play an active role in overcoming one of the typical difficulties - the allocation of debts between the new companies, particularly when loans have been collateralized with pledged assets.

3.26 The problem is more complex for public enterprises, many of which exhibit natural monopoly features (the electricity and the telecommunication company), and for INA. Although their privatization is a stated Government objective, and the new Privatization Law pledges 25 percent of their equity for pension reform purposes 54, a full-fledged strategy to achieve this objective has not been formulated yet. Other countries' experience suggests that privatizing public enterprises can be a lengthy and technically complex process, particularly if objectives such as demonopolization, and transfers of technology, are to be fully achieved. Successfully privatizing, in a reasonable time frame, the key public enterprises implies intense work on three major fronts: some of these entities need to be broken up or reorganized in-depth; a regulatory framework conducive to the entry of private operators must be established; and the Government must build up its own capabilities to conduct and coordinate the privatization process. These issues arise in different terms for two companies essentially involved, and are reviewed below.

Telecommunications

3.27 Croatia's telecommunication sector has a fair degree of development, relative to most central European countries, and this should facilitate its privatization and opening to competition. As observed in Hungary, privatization could generate substantial revenues for the State and, in Croatia's specific circumstances, contribute in a major way to capitalize the future multi-pillar pension system. However, little enthusiasm for such a prospect seems to be shown by the postal and telecommunication company, nor by some key policy makers. The authorities seem to fear, inter alia, 'cream-skimming' by private operators, at the expense of areas with less traffic potential. The draft law on Postal Services and Telecommunications, recently submitted to parliament, provides for the separation of the two entities as a starting point. But the authorities expect the separation to take one year, as fully distinct organization, and especially financial accounts, will need to be established for the two activities.

3.28 Recent world-wide experience suggests that privatization can result in greater efficiency, and welfare gains for consumers, if the adequate conditions are fulfilled. In Croatia, besides the separation of postal services and telecommunications which should take place as soon as possible, these conditions are threefold. First, tariffs should be rebalanced in order to: (i) turn

53 The company law authorizes splitting only companies whose all shares had been fully paid for. The new Privatization Law clarifies that this does not apply to former socially-owned enterprises whose shares have been subscribed but not fully paid for. The Privatization Law states that 25 percent of the public enterprise shares are to be allocated to pension reform purposes. The Law seems to foresee that this transfer will not take place in its own right, but as and when a particular public enterprises is otherwise privatized. It does not state either how the 25 percent stake is to be used. 42 local communications -- currently cross-subsidized by long-distance communications -- into a potentially profitable activity; (ii) improve penetration rates; and (iii) avoid conferring rents to private sector operators. Second, HPT should consider opening the market to competing operators. Third, the entry of such operators requires a regulatory framework establishing clear rules for tariff and tariff adjustment, access to network, and resolution of commercial conflicts. Should the authorities so desire, regulations could also mandate that operators contribute to a 'universal service fund', that would help expand coverage in less profitable areas.

Electricity

3.29 The situation is similar in the electricity sector. No concrete steps have been taken towards the reform of HEP, the monopolistic and vertically-integrated public enterprise, although the 1994 law on the electrical industry provides for a fundamental reorganization of the sector, namely: (i) the unbundling of HEP in three parts - generation, transmission and distribution; (ii) the opening of generation, and of distribution, to private operators, with only transmission to remain the exclusive domain of a majority state-owned enterprise; and (iii) the possibility for the Government to privatize 25% of HEP's equity without further Parliamentary approval. The lack of progress so far in this sector reflects an unsatisfactory situation whereby sector policies are largely driven by the enterprise, rather than by the line ministry. The reorganization of HEP is a priority if privatization is to take place in a way that promotes efficiency and competition, and should be concluded along two lines. Vertically, HEP should be separated into generation, transmission and distribution entities. Horizontally, generation and distribution should be split into different production units and regional distribution networks, respectively, that would be allowed to compete. As in the telecommunications sector, a regulatory framework governing tariff-setting, access to network and commercial conflicts, should also be established. If these steps are not taken, international investors who are actively evaluating opportunities in power generation in Central and Eastern Europe may lose interest in Croatia, and the country may forego for some time the benefits of a rapid inflow of external equity and expertise in this strategic sector. Alternatively, the electricity company may be able to attract investors by offering them profitable 'power purchasing' contracts, but at the cost of a loss of welfare for Croatian consumers.

Privatization in the Agriculture Sector

3.30 Private sector development has been slower than average in the agriculture sector, because of two specific factors: the complex and unwieldy nature of the formerly socially-owned agrokombinats55 ; and the concentration of large land holdings in State hands. The resolution of these two issues needs particular attention in the design of private sector development policies in the agriculture sector.

55 Sixty-five percent of the estimated value of the 123 agriculture and fisheries enterprises remaining in the CPF portfolio is concentrated in 12 agrokombinats, all of which constitute single holding companies of disparate enterprises. Preemptive rights to the acquisition of shares offered for sale and lack of transparency in company management and operations frustrate the entry of new equity partners. The conglomerate structure also weakens incentives for efficient management, by allowing non-market transfer prices and cross-subsidization across the holding's different activities. In many cases, the resources now clustered in conglomerates would be used more efficiently be separate and smaller units. Increasing competition downstream, in particular, would address inefficiencies at the processing and marketing stages, and facilitate the reduction of protection levels for processed products. 43

PrivatizingAgrokombinats

3.31 The privatization and restructuring of agrokombinats should be accelerated using a two- pronged approach. On the one hand, agrokombinats whose corporate structure is relatively straightforward should be privatized in the framework of the upcoming round of voucher privatization. On the other hand, 8 to 12 agrokombinats with complex holding structures should be unbundled into individual enterprises, which should be registered as legally separate entities and made available for privatization. The former holding companies should by and large become redundant. While the more promising subsidiaries are likely to find investors, some of the constituent enterprises may remain on the books of the CPF, and become candidates for liquidation sale.

Land Markets

3.32 A severe handicap for private farming development is the small size of farms (around 3 ha on average) and their fragmentation into many smaller plots, partly as a result of the size limits imposed on private farms in the constitution of the former Yugoslavia.

3.33 A way to help improve the structure of agriculture farms would be to let markets reallocate the large holdings of land currently in State hands. The State owns 37% of agricultural land, as a result of the transfer of ownership of the kombinats' land in 1991 (Law on Agriculture Land). So far, only a very small fraction (125 ha) of state-owned land has been sold. One obstacle has been unclear property rights, as a considerable amount of this land had been nationalized after 1945. A recently adopted restitution law now provides a framework to resolve the likely claims from former owners. Although land that was State-owned prior to 1945 is not subject to these claims, it has not been sold, but partly used by the agrokombinats without payment of lease or land tax; other parts have either remained idle, or been leased to family farms and agrokombinats through a tendering process. A land policy strategy should include a program to return land to use, through sales or leases, and the development of a legal and regulatory framework that should allow for the functioning of an efficient land market. Privatization will allow land to move back into productive use under secure property rights. When property rights are secure and registered, land mortgages can develop as a financial instrument, and private investment in the sector will increase. Well functioning land markets reduce the costs of buying, selling, and leasing, and improve prospects for much needed land consolidation.

3.34 Returning Land to Use. While land sales rules have been established under various amendments to the Law on Agriculture Land, program implementation has lacked decisiveness so far. The Government should now proceed with an aggressive program of land sales or, where reprivatization claims exist, short-term leases in every county. The decision to award tender contracts should be made by the County Land Council. In order to stimulate demand, buyers should be given the option to pay either in cash or in installments. Leaseholders should be given the right to purchase land (at market prices but with the option of installment payments) if reprivatization claims are settled by means other than in-kind return.

3.35 Land Registry and Cadastre. In addition to the divestiture of State property, markets should be allowed to complete, and adjust to changing needs, the process of land consolidation. This will require the strengthening of key market institutions such as land registries and cadastre. The Government should develop a computerized nationwide data base for both cadastre and land register purposes, in order to link cadastre and land registry data. This requires that the draft 44

Land Registry Law, prepared by the Government, be amended to allow computerization of both cadastre and land registry, and processed through Parliament. Regulations should also allow for easy electronic access to the data by the public. CHAPTER FOUR

HOW TO STRENGTHEN FINANCIAL INTERMEDIATION?

4.1 The development of Croatia's private sector requires a strong and competitive financial system that can help mobilize domestic savings and allocate them, at the least cost, to the most efficient enterprises, exercise financial discipline, and allow the ownership structure of privatized enterprises to evolve over time. These functions have been fulfilled only to a limited extent to date. In spite of the ongoing remonetization, the allocation and the cost of credit have been severely distorted by the current enterprise crisis, which has spilled into large parts of the banking system. In addition to insolvent banks, bank intermediation has generally been stifled by low profitability levels, insufficient competition, and the slow transformation of the ownership structures inherited from the past. The underdevelopment of capital markets has done little to improve this overall picture. This Chapter discusses the policies that can be implemented to stimulate the development of financial intermediation in Croatia, both by the banking system (Section I) and by capital markets (Section II).

SECTION 1 - STRENGTHENING BANK INTERMEDIATION

The Banking System Crisis

4.2 Croatia's banking system has be2Com, its ownrig a stle ts Table 4.1: Main Monetary and Credit Aggregates become, in its own right an obstacle to19- investment and growth: real lending rates real increase have been hovering around a high 20 Sthe past thre years, and Net Foreign Assets N.A. 156.8% 133.1% percnt pa. ufln eeDomestic Credit 12.5% 7.0% 6.7% scarce access to credit is cited by many oeret 15.5% -. 5% 6.6% Croatian enterprises as a key constraint to - Gonm 31.5% -4.6% 12.8% their development. Contrary to what has Mony Mny77.8% 36.2% 44.5% been argued in some Croatian circles, this Momey 97.8% 16.9% 47.5% situation has little to do with current - FCuec 67% 16.9% 47.5% monetary policy. Admittedly, the banking Other (net i7abilities) -0.4% -3.3% -10.3% system has considerably increased its claim on the foreign sector (Table 4.1), as a result increase as % of GDP of capital inflows in a stable exchange rate Net Foreign Assets 3.6% 2.0% 4.1% context: by 10 percent of GDP during Domestic Credit 4.2% 5.0% 4.8% 1994-96. But the extent of the recent - Government -4.0% -0.5% -0.5% remonetization, combined with sound fiscal - Economy 8.2% 5.4% 5.2% 56 policies , also left considerable room for Money 8.5% 7.5% 11.7% credit expansion: credit to the economy - Domestic 4.6% 1.9% 4.2% increased even faster than the foreign assets - FX Currency 3.9% 5.6% 7.5% of the banking system, by 19 percent of Other (net liabilities) -0.7% -0.6% -2.8% GDP during the last three years (Table 4.1); the pace of credit growth has slowed down since 1993, but was still 13 percent in 1996 (i.e., faster than nominal GDP growth).

56 Budget deficits remained low, and were financed externally; in addition, the Government reduced its debt to the banking system through amortization. 46

4.3 What then caused the credit crunch? The available evidence suggests that the allocative role of the banking system has been severely affected by the extent of the losses in the enterprise sector. The profitability and financial condition of at least four banks, accounting for half of the banking system's assets, has been severely impaired by their mounting non-performing loan 7 . As observed in other transition countries, the main problem posed by bank insolvency of systemic proportions is its impact on incentives; troubled banks cannot impose financial discipline on their borrowers, and force their restructuring or liquidation, without recognizing their own predicament. This leads them to bail out troubled borrowers through rolling over past due loans, capitalizing interest, or even increasing their exposure. Although troubled banks have been prohibited by the NBC from increasing nominal credit to some large loss-makers, the measure was not effective enough. The targeted loss-makers accounted for a decreasing share of enterprise losses58 and, in any event, have been able to circumvent credit limits through inter-enterprise credit including cross-financing within a same group. As a result, the cash losses of enterprises59 helped to artificially increase the demand for credit crowd out sound borrowers, and push interest rates upward.

Beyond the Short-term Crisis: Structural Weaknesses

4.4 As mentioned in Chapter III, the troubled banks are now undergoing Box 4.1: Croatia's Banking System rehabilitation, and steps should be taken by the BRA in order to subject their borrowers Bank intermediation is still relaiely shallow in Croaua. but has to financial discipline. Will the resolution of been deepening s nee the stabilization of 1993: total deposits the current bank-enterprise crisis suffice to w%ere equj%alent to aLmost 45 percent of GDP at end-1996, up from 25 percent oj GDP three }ears before The banking system turn Croatia's banking system into an includes 55 banks tearly 1996), of which 21 date back to the efficient one? In spite of significant former SFRY times, and 33 were established since independence. transformations over the past five years, the Among these, only one foreign bank started operating in Croatia privatization of a number of pre- IRaiffensen Bank from Austria), although neither regulations nor . policies pre%ent the enEry of foreigners. Despite their proliferation. the new banks account for only 10-12 percent of new ones (Box 4.1), the answer is the market. by loan or deposit measures, with the largest single ambiguous. Bank profitability is abnormally market share at about 2 percent of total. The 'old' banks include. low, which threatens to slow down or besides the four banks undergoing rehabilitation. 9 banks which prevent, from the supply side, the decline in Aere'priatized'. through the privatization of their owners, and 8 banks still publicly-owned (i.e, the maJoriry of the enterprises interest rates that could otherwise be owning them ha'e not been pritauzed). As per these definitions. expected from the reduction of enterprise the share of the prnate banking system was about 50 percent of losses. This predicament does not spare the total at end-1995. When the four troubled banks are pri%.atized. new banks established after 1991, which this share will be 90 percent. have failed to emerge as strong players in the banking field. Finally the ownership and governance of banks continues to be dominated by enterprises, even though many of these enterprises are now private or privatized. This feature of Croatia's banking system remains a cause for concern.

57 Privredna Banka Zagreb (PBZ), which accounts for 25 percent of the banking system's assets; and three smaller, regional banks: Rijecka Banka, Splitska Banka, and Slavonska Banka. As shown in Table 4.2, these banks report positive equity and profitability. Both would be negative, however, if interest income were properly accounted for, and provisions for bad loans adequately made. 58 Twenty-five percent of total losses in 1994, and only 10 percent in 1995.

59 About 5 percent of GDP during 1995, broadly equivalent to the new credit flows. 47

A Constraintto Lower Interest Rates: Low Bank Profitability

4.5 The profitability of Croatian banks is disturbingly low. At current intermediation spreads -- 15 percent or more, an efficient and normally-leveraged bank60 would be expected to achieve returns on equity in the neighborhood of 100 percent. In Croatia, returns on equit01 average only 3.5 percent, and range from 1 percent in troubled banks, to a still inadequate 6.9 percent. in privately-established banks (Table 4.2). Only a handful of smaller banks achieve returns of 30-40 percent (Graph 4.1). As a result, the banking system as a whole is not likely to resist any major decline of interest rates, which could imply a systemic destabilization. What went wrong? To answer this question, one needs to assess the two parameters of bank profitability: the net return on assets, and the 'leverage' facto 6 2, which are both abnormally low in Croatia.

Table 4.2: Key Banking System Indicators (1995)

Number of hanks 53 8 9 DISTRIBUTION OF: Total Assets 100% 46.6% 8.9% 34.7% 10.8% Loans 100% 42.1% 7.3% 37.9% 12.7% Deposits 100% 34.0% 10.1% 44.2% 11.7% Equity 100% 44.1% 11.1% 29.9% 14.9% COST OF INTERAMEDIATION (AS A % OF TOTAL ASSETS) Interest Income 9.4 11.7 11.2 16.0 Interest Expense 3.5 3.0 3.9 3.9 4.5 Interest Margin 5.9 3.1 7.7 7.3 11.5 Oper. Expenses 3.9 2.7 6.4 3.9 6.4 Provisions 1.2 0.1 1.0 2.1 2.9 Net Margin (return on assets) 0.8 0.3 0.4 1.2 2.2 Cost of Non-Market Assets 4.6 1.8 7.8 6.4 6.6 OTHER INDICATORS (%) Return on Equity 3.5 1.2 1.4 6.0 6.9 Implicit Interest Rate on Loans 15.2 9.5 23.5 16.8 24.7 Implicit Cost of Liabilities 4.6 3.8 5.4 4.9 6.5 KEY BALANCE SHEET iTEMS (E-XPRESSED AS A MULTIPLE OF EQUITY) Total Assets 4.4 4.6 3.6 5.1 3.2 Loans 2.5 2.3 1.7 3.1 2.3 Claims on the Government 1.1 1.3 1.0 1.4 0.2 Claims on the Central Bank 0.1 0.1 0.1 0.2 0.2 FX Deposit Requirement 0.4 0.3 0.3 0.7 0.3 Investment Portfolio 0.3 0.6 0.4 0.1 0.0 Deposits 2.3 1.8 2.1 3.4 1.8 Borrowings 1.1 1.8 0.5 0.7 0.4 Source: Financial statements of banks and World Bank estimates

60 Assuming operating costs of 3 percent of total assets, the norm in developed banking systems; and risk assets of 10 times equity, resulting in a prudent capital adequacy ratio of 10 percent. 61 As officially reported by banks (potentially overstated in many cases). 62 A bank's return on equity is equal to the product of its average return on assets (net results divided by assets) by its leverage (total assets divided by equity). 48

4.6 Net Return on Assets. As shown in Table 4.2, Croatian banks achieve returns on assets ranging from .3 percent (troubled banks) to 2.2 percent ('new' banks). Only three banks (Graph 4.2) reach the 8-10 percent return on assets that one would expect, at current lending rates -- discounted for non-performing loans -- and cost of resources. The discrepancy between actual and potential results is, in part, due to the need to provision bad loans, and to operating costs that are on the high side 63. But it results mainly from the cost of 'financial repression': as much as 37 percent of the banks' assets yield no net income over the cost of their resources, or no income at all, as a result of past Government financial policies, and current monetary policy requirements (Box 4.2). To a large extent, financial repression implies that enterprises are cross-subsidizing, by paying higher than- necessary interest rates, the Government and the Central Bank. Should non-market assets earn the same effective yield as loans, banks could achieve returns on equity in excess of 30 percent, even with the low leverage at which they currently operate (see next paragraph); or decrease lending rates by 8-9 percentage points at current profitability levels; or seek some combination of these two outcomes.

Box 4.2: Financial Repression

One vf tre factors affecting the profltability of the Croatian banks is the high proportion of their assets immobilized in non- markt claims. These account, on aerage. for some 37 percent of total assets. and include:

S Foreigii exchange claims on the Government (14 percent of assets). These were recognized in 1991 to compensate banks tor ie loss' of their foreign exchange deposits which they bad to surrender to the Central Bank of Yugosla%ia for local currenI ohich was de%alued). These claims are amortizable o%er 10 Nears. starting in 1995. but generate no net income for banks. as the inerest rate matches the cost of deposits. * The 'big bonds' (7 percent of assets) issued by the Government in 1991 to enterprises in difficulty to repay their bank loans. The bic bonds turned out to be non-performing assets themsel%es the principal - indexed on the producers pnce index, .s repaid ;n 20 equal annual payments. but they do not bear interest. a T%k o categories of assets resulung from monetary policy requirements (16 percent of total): claims on the Central bank (manciaior, reseres and bills averaging 35.8 percent of domestic deposits). and remunerated at about the cost of resources; and treign u change claims on foreign banks Croatian banks must redeposit abroad, at a zero or negative margin, about 40-45 prcrit ot their 'news' foreign exchange deposits, meaning those collected since 1991).

B0, -inarker inierest rates also preclude those assets wkhich could potentially be tradable Ithe big bonds and foreign exchange bond frcm being sold by banks, because of the capital loss that would ensue. This deprives banks from a liquidity managemeni instrument. and does little to impro%e the scarce supply of interest-beanng secunties on capital markets.

4.7 Low Leverage. Another factor behind low bank profitability is the very low leverage of their equity resources: total assets, including non-risk assets, stand at only 3-5 times capital (Table 4.2 and Graph 4.3), while this ratio would typically stand at least at 12-15 in an efficient banking system6 4 , allowing much lower interest spreads for an equivalent profitability. Even under optimistic assumptions of financial deepening, and/or increasing internediation of foreign savings, Croatia's banking system is unlikely to achieve market economies-like leverage levels in the short- term. The implication may be twofold. On the one hand, the capital of a number of banks may be overstated, which would call for a more stringent definition, and enforcement by bank supervisors,

63 On average, 3.9 percent of assets and 6.4 percent in 'publicly-owned' and privately-established banks. Typically, efficient Western banks contain their operating costs below 3 percent of assets, sometimes closer to 2 percent.

64 A capital adequacy ratio of 8 percent on risk-weighted assets, the so-called 'Cooke' standard, translates in a leverage of 12.5 (i.e., 1/8). Higher leverage is perfectly acceptable on account of the other, non- or low- risk, assets that are part of a bank's total balance sheet: not only fixed assets, but claims on the Government. 49 of accounting and provisioning rules. On the other hand, there may be excess capacity in the banking system, a situation that one would expect to see corrected by voluntary or involuntary exit of banks in the future.

The Slow Emergence ofNew Players

4.8 The entry in Croatia's banking system of as many as 30 new players, prompted by the liberalization of entry policies and the high intermediation spreads, has failed to spur competition in a major way. New banks account for only 12-13 percent of total loans and deposits (Table 4.2); none of them represents more than 2.5 percent, and most less than 1 percent, of the banking system's assets (Graph 4.4). The banking system remains dominated by the only two nationwide networks (one of which belongs to a troubled bank undergoing rehabilitation), which account for close to 60 percent the banking system's assets. The next four, second-tier, banks make up another 20 percent, and three of them are under, or are emerging from, rehabilitation.

4.9 Two different barriers to entry are slowing down the development of new banks. One, present in any market, is the difficulty of penetrating the deposit market, particularly the cheaper household deposits, as well-established banks continue to enjoy the confidence of the public. As shown in Table 4.2, this is reflected by deposits to equity ratios that are lower than in the rest of the banking system (1.8 vs. 2.3 on average, and 3.4 for privatized banks), and by a higher average cost of deposits (6.5% vs. 4.6% p.a.). The other obstacle, more typical of transition economies, lies in the scarcity of customers with a solid track record, and the higher costs associated with loan origination. This is illustrated by average lending rates that are higher than in other banks, and relatively high provisioning levels (2.9 percent of assets in 1995, vs. 2.1 in the privatized banks). These constraints have combined to reduce the profitability, and thus potential for expansion, that new banks should have enjoyed at current intermediation spread levels. The average return on equity, 6.9 percent, is hardly higher than in privatized banks (6 percent) and very low in absolute terms. Although new banks do enjoy much higher intermediation margins than others (11.5 percent, relative to total assets, vs. 5.9 percent), this comparative advantage could be even higher if cheap deposits were forthcoming. It is almost offset by higher operating costs and provisions, and lower leverage levels, than average, all factors associated with the difficult search for creditworthy customers. Modest profitability, in turn, constrains the investment effort that would be needed to increase market shares, typically the expansion of branch networks.

Issues with Bank Ownership and Governance

4.10 Most of the banking system -- except the banks undergoing or emerging from rehabilitation -- is already privately-owned: the eight pre-independence banks that are still publicly-owned account for less than 10 percent of the banking system (Table 4.2). Once the banks undergoing rehabilitation are privatized, 90 percent of the banking system will be in private hands.

4.11 Although these numbers are impressive, one should remain concerned by the 'quality' of bank ownership in Croatia, and its effect on bank governance. Bank privatization was 'indirect', and entailed few changes of owners, or entry of new ones. Although the transfer of banking skills from market economies would clearly bring considerable benefits to Croatian banks, none of them has entered into equity or other technical assistance partnership with foreign banks. Instead, the old shareholders, usually former socially-owned enterprises, were simply privatized themselves as a result of the implementation of the Transformation Law. Indications are that the new banks themselves have been, more often than not, established by enterprises. Considering the past history of Croatia's banking system, enterprise ownership of banks, and the resulting risk of related party 50

Croatia: Bank by Bank inaicators (Selected Banks)

Graph 4.1: Return on Equity of Croatian Banks Graph 4.2: Return on Assets of Croatian Banks 0.5 e14%

12% ------_ - _ - 0.4 - - --

010% ------

o 02---0.2 -- 40

CL 6-% ------4%------

-0.1

0%0v

1 3 5 7 9 11 13 15 1? 19 21 23 25 27 29 31 3? 35 37 394 4 -0.2% 0.0.3 2%------

-0.3 -4%

Graph 4.3: 'Leverage' of Equity in Croatian Banks Graph 4.4: Distribution of the Banking System's Assets

120 0.250

0 -- 20.2

415

& 0.1 4

0.05-

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 313 35 37 39 41 3 45 47 51 lending remains a cause for concern. What mitigates this concern is that the ownership of privatized banks is often much more dispersed than was that of the troubled banks, making it more difficult for corporate shareholders to skew lending decisions. The risk, however, remains, and should be duly addressed by bank supervisors.

Policies for the Banking System

4.12 The banking system reform agenda will be demanding in the coming years. Beyond the resolution of the four problem banks, the banking authorities should stand ready to walk a tight rope: a strong banking system serving better the needs of the economy implies more competition, and lower intermediation margins; but, under current conditions, any progress towards these objectives may destabilize parts of the banking system, and erode the profit base that is required to improve skills and policies, invest in technology, and expand branch networks. Current levels of bank intermediation, deposits and credits, are still low, and may or may not expand rapidly enough to support adequate returns on the capital presently invested in the banking system. This could make it unavoidable for the weakest banks to exit the market, an outcome that the authorities should be ready to manage in an orderly manner. In this uncertain environment, there are three sets of policies which should be implemented, besides the resolution of the four problem banks, as they appear likely to enhance in any event the stability and the effectiveness of the banking system: reduce current levels of repression on the banking system; establish a system of deposit insurance, while strengthening the regulatory and supervisory framework; and increase the banks' ability to secure their operations.

Restructuringand PrivatizingTroubled Banks

4.13 Bank Privatization. The takeover of troubled banks by the State provides a unique opportunity to seek for them, in the private sector, more effective owners than in the past. Bank privatization should be pursued through a two-pronged approach. First, governance considerations, and the much-needed infusion of skills and technology, calls strongly for domestic, but more likely foreign, financial institutions to enter in troubled banks as strategic or controlling partners 65. As soon as possible after the transfer of non-performing assets to the BRA, and their initial restructuring, the banks should therefore be offered to potential new owners. Their entry would offset part of the costs of recapitalization, and relieve the BRA from the burden of carrying out their restructuring. A second layer of bank capital could be offered to Croatian depositors (either to the depositors the bank for sale, or to depositors at large), particularly the holders of 'frozen' foreign exchange deposits. Such a scheme, patterned after that successfully implemented by the CPF for enterprises, would simultaneously achieve several purposes: dilute the State's ownership in troubled banks; reduce the need for 'fresh' capital; and extinguish public debt.

4.14 Bank Restructuring. Until they can be privatized, and as a way to facilitate privatization, banks under rehabilitation need to undergo deep operational restructuring. Clearly, troubled banks have high overheads levels, whose significant reduction needs to be achieved in order to help restore profitability. What troubled banks most need to achieve, however, before they can be deemed restructured, is nothing less than a full reengineering: strategies need to be defined, and organization, branching and staffing adjusted accordingly; risk management, particularly

65 Because of the banks' history, non-financial enterprises should be severely restricted from the prospective ownership. 52 credit, liquidity and foreign exchange, need to be considerably strengthened, and formalized; budgeting must be brought to international standards and, in some cases, established; and productivity levels must be increased, particularly through wider use of information technology.

Alleviating FinancialRepression

4.15 Within fiscal and monetary policy constraints, a medium-term goal of banking policies is to alleviate what is a clear-cut case of financial repression. The immediate candidates for yield and/or liquidity improvement are the two State bonds issues, the 'big bonds' and the foreign exchange bonds. At a minimum, the Treasury should remain firmly committed to the policy followed since mid-July 1996 (i.e., make timely interest and principal payments in cash, as initially scheduled). A more desirable option would be to redefine the features of these assets, so as to allow banks to earn a net spread over the cost of their resources. A third option would be for the Treasury to implement prepayment policies, which would allow banks to progressively improve the composition of their assets. There is, arguably, a lesser degree of flexibility on the side of monetary policy requirements. Phasing out the obligation to redeposit abroad 40-45 percent of foreign exchange deposits is, however, a desirable objective over the medium-term6 6 . Progress could be made as and when pressures to appreciate the exchange rate abate, and bank management of the foreign exchange risk improves. Faster improvements could possibly be made towards decreasing domestic reserve requirements, if the Central Bank were to switch more aggressively the focus of sterilization policies onto auctioned bills.

DepositInsurance, Regulation and Supervision

4.16 The establishment of a deposit insurance scheme, envisioned under the Bank Rehabilitation Legislation, could help Croatian policy-makers achieve simultaneously three goals: level the banking 'playing field', and help newer banks expand their deposit base; build up the institutional capacity, and financial resources, for resolving future bank crises, if any; and improve supervision along the way. However, ill-designed deposit insurance could also introduce a moral hazard element in the banking system and, as seen in other countries, trigger rather than prevent a banking crisis. In order to defuse this risk, remaining weaknesses in the bank regulatory framework must be fixed, and bank supervision improved, including by empowering the deposit insurer to conduct its own supervision.

4.17 Regulatoryframework. The regulatory framework for banking activities was overhauled in 1992-93, and brought close to European Union standardS67. In particular, NBC's prudential regulations define appropriate requirements or limits for minimum entry capital, capital adequacy, large exposures, foreign exchange positions, currency risk, and equity investments. There appears, however, to be scope for improving regulations in at least three areas. First, more severe limits should be imposed on related party lending, a threat which is still very much present in CroatiO.

66 Provided bank supervisors enforce strictly the broader foreign exchange cover regulation, which prohibits banks from maintaining an 'open' foreign exchange position in excess of 15 percent of their share capital. 67 With a new Law on the National Bank of Croatia, a new Banking Law, and a set of NBC regulations. 68 As discussed, little has changed in the ownership structure of many banks, except that their owners were privatized. Only troubled banks are undergoing a radical change of ownership structure, since the previous shareholders lost their equity. 53

Although a law of 1995 did introduce a stringent limit on aggregate lending to related parties (no more than 5 percent of a bank's equity), this limit applies only to shareholders holding more than 5 percent of the bank's equity, and is likely to be ineffective in many banks. NBC should tighten the regulation, to apply to all shareholders, or shareholders holding more than, say, 2-3 percent of the bank's capital. Conversely, the limit on aggregate lending to related parties, relative to capital, appears to be overly rigid, and could be relaxed to 30-50 percent of capital. Second, key accounting rules need to be brought to Western banking standards, to present a truer picture of the banks' financial condition, and avoid undue complacency by bank managers69 . Third, regulations conducive to improvements in bank corporate governance should be introduced, especially the requirement of 'fit and proper' directors and management, and the mandatory establishment of audit committees and internal auditors.

4.18 Supervision. Important as they are, these regulatory improvements will do little to promote banking stability, in the absence of stronger supervisory capabilities. Although the NBC has undertaken an ambitious effort with this respect7O, it will take time, as in all transition countries, for supervisors to adapt fully to the new paradigm: induce banks to manage their risks, rather than comply statically with monetary, or other, regulations; build an off-site surveillance system allowing early detection of potential problem banks; and promptly conduct state of the art on-site supervision, or intervention. In view of this heavy agenda, two additional measures could help accelerate the build up of an effective bank supervision function. One would be for the Central Bank to use international auditing firms for supervisory purposes, with a requirement to train its staff along the way. This assistance would be of particular value for supervising larger banks, complex transactions, or for intervening problem banks. Second, the BRA, as the designated manager of the future deposit insurance scheme, should be allowed to build its own supervisory capabilities, as this would be consistent with the need to assess risk, set premium levels and, if need be, intervene troubled banks. As a newer institution, the BRA may have greater flexibility than the NBC in staffing decisions, use of external technical assistance, or outsourcing.

Secured Lending

4.19 One key feature of well-functioning financial systems is the ability to improve lending and borrowing capacity by using asset-based lending: the pledge of property as a collateral induces the lender to take a lending risk that it would not have taken otherwise, while the borrower is able to leverage its assets into additional funds. In mature financial systems, asset-based lending uses nearly all forms of property as collateral for secured lending, and secured interest are able to be enforced. While the concept of asset-based lending using property as security exists in Croatia, the regulatory framework for secured lending and the institutions required to register property rights and pledges are either weak or missing in their entirety.

4.20 Regulatoryframework. Croatia does not have a specific 'collateral' law which clearly states the rules for secured lending (i.e., the owner's right to pledge its property and the procedures

69 Stricter rules should mandate the suspension and reversal of interest accrued but not perceived after a certain delay, in order to avoid overstating bank income. Capital adequacy is also overstated because of: (i) a definition of the capital that is too comprehensive; and (ii) a system of debt classification and provisioning which is too loose (based only on actual overdues, not on prospects for repayment). 70 NBC's program to strengthen its supervisory capacities cover both off-site and on-site supervision, and relies on external senior advice, training, and considerably increased human resources (a threefold increase in staff, to about 40). 54 whereby lenders can enforce their rights). Instead, Croatia is able to achieve minimal asset-based lending, through a whole variety of laws - not all of which are in harmony. Most civil law countries have, in addition to their companies law, a code for commercial transactions which includes, among other things, the methods and procedures for asset-based lending. Croatian lenders, and particularly the banking system, would benefit from an effort to review the many laws which affects secured lending, and harmonize them into a clear code of commercial transactions. Alternatively, Croatia could adopt a specific collateral law providing clear rules for secured lending, and overriding previous legislation.

4.21 Registration of ownership rights and pledges. Croatia has in principle clarified property rights -- with the exception of the restitution issugl -- and moved away from social, to either State or private, ownership. Secured lending, however, is hampered by the difficulty for owners to establish unequivocally their rights, let alone for secured lenders their collateral. Real estate registries exist, but have not been consistently maintained after World War II. They should be updated and computerized to provide better accuracy of titles and reflect the new private ownership rights. Moreover, the legislation and registries should be modified to address the more complex issues related to multiple-ownership (i.e. flats) or multiple-use (i.e. mixed commercial and residential space) buildings. While there is car and truck vehicle registration, there is no ability, currently, to register a lien against a specific car or truck pledged as collateral for a loan. Consequently, there is little vehicle purchase or lease financing available in Croatia. As discussed in the next Section, a similar situation prevails for shares of companies.

SECTION 2 - CAPITAL MARKETS

Recent Developments

4.22 Croatia has made a head start in terms of developing a legal, institutional and tax framework for financial markets, but the levels of activity remain fairly low, although they have been on the rise recently. The Zagreb Stock Exchange (ZSE), which had been operating until World War II, reopened in July 1991, and has as members the lead domestic banks, insurance companies, and brokerage firms72. Western-type securities and investment fund legislation were adopted in December 1995. The 'consumed revenue' approach elected by direct taxation (see Chapter VII) shelters dividend and interest income, as well as capital gains, from taxation. A modern registry, transfer and settlement system is being established.

4.23 Only in 1996, however, did activity start to pick up. Until then, the ZSE, in particular, had been essentially used as a vehicle for the CPF to divest its residual holdings in former socially- owned enterprises. Sales remained quite modest and, in addition, failed to attract 'fresh' capital as

71 The 'Law on Compensation for property taken during Yugoslav communist rule' was passed by Parliament on October 11, 1996 and came into force on January 1, 1997. It provides for in-kind restitution when possible, in cash or in shares otherwise. The process of dealing with 70,000 claims, covering 30,000 flats, 16,000 business premises, and 50,000 plots of land, promises to be complex and protracted. 72 Forty members including 17 Croatian banks, 2 insurance companies, and 21 brokerage houses. There are also three independent over-the-counter (OTC) markets in Zagreb, Varazdin and Osijek. 55 they were essentially concluded against frozen foreign exchange deposits73. The successful floatation of two 'blue chip' companies in 199674, Pliva and Zagrebacka Banka, did much to bring market capitalization to its current, but still modest, levels of about 10% of GDP. But the ZSE's 'full' listing includes only four stocks, although another 76 companies have been admitted to the 'partial' listing75. In addition, trading remains modest although it has picked up from about US$160 million in 1996 to about US$595 million through the first three quarters of 1997.

4.24 Two sets of constraints have been hampering further development of the capital markets. First and foremost, demand for financial assets has been extremely weak -- not solely the result of low domestic savings. The second set of constraints have been the absence of a well-established 'watchdog'76, the lack of safe registration and settlement procedures, and the modesty of the institutional investor sector. The latter set of constraints are been addressed under a program of development of capital markets. These issues have contributed, besides the political uncertainties of the past six years, to depress foreign demand. But domestic institutional demand is also shallow. The 17 Croatian insurance companies collect premiums equivalent to 3.5 percent of GDP, but operate to a limited extent in the life insurance segmenft 7, which typically generates most of the demand for long-term financial assets. Investment funds, which have boosted demand for securities in many developed markets, are conspicuous by their absence in Croatia. This also results in part from the inadequate supply of financial assets. However, legislation has been being prepared and sent to Parliament for approval, for the establishment of investment funds.

4.25 On the supply side, ineffective 'second-stage' privatization methods have very much contributed, as already mentioned, to keep marketable stocks in State hands. Many of the natural candidates for full listing or initial public offerings still have their equity locked up in the books of the Pension Fund and the CPF. Overvaluation, a politicized decision-making process and, in some cases, management resistance to opening up the capital, have slowed down the divestiture process. The haphazard distribution of equity stakes to State creditors did not do much to resolve this issue either, nor has it been conducive to attracting outside investors. On the secondary market, the initial overvaluation of many shares subscribed during the initial privatization round acts as strong disincentive to resell, particularly when outstanding purchase loans, which become immediately due when shares are sold, exceed the market value. Another impediment to market development, particularly to investment fund-driven demand, has been the lack of interest-bearing securities, a key vehicle for risk-spreading and portfolio diversification. As far as the Treasury is concerned, the marketability of bonds issued in the past, the 'big bonds' and the counterpart claims of frozen foreign

Share sales equivalent to about US$1,500-million were concluded, of which an estimated 90 percent through swaps of frozen foreign exchange deposits, and the balance for cash. Combined with an international offering of Global Depository Receipts on the London Stock Exchange. 75 Fully-listed companies meet the most stringent disclosure, market capitalization, and other listing requirements, such as three years of audited financial statements. Other companies' stocks are traded on a second market. 76 Although the Securities Law of 1995 calls for the establishment of a Securities and Exchange Commission (SEC), the commissioners were appointed only recently and the SEC has not been able yet to fully establish itself as a credible market authority. It has, in particular, a considerable agenda in terms of defining ethical conduct rules, licensing criteria for market players, etc. 77 Life insurance is 5.6 percent of total premia. 56 exchange deposits, has been affected by legal restrictions78 and, more seriously, by the rescheduling of principal or interest payments in several occasions. New Treasury bond issues have been limited by the fact that the Treasury currently finances its deficit externally, and has been reluctant, until the recent decrease in money market rates, to issue short-term instruments79 That few other issuers have been forthcoming, with the exception of two municipal bond issues, is somewhat surprising, considering that the large bank spreads have left considerable: room for disintermediation. Possible explanations include the deterring effect of interest rates, even at levels that would be lower than bank lending rates, on borrowers; banks' reluctance to encourage disintermediation, which could further reduce their profitability; the general underdevelopment of other market professionals, such as brokerage firms or investment banks; and investors' perception that enterprises' financial statements are, sometimes, less than reliable.

Developing Capital Markets

4.26 Capital markets development usually reflects a country's overall wealth and savings. It often takes time, investor education, a well-established record of financial security, and should remain market-driven. This is not to say that there is nothing that the State can do. It should, indeed, take every step to ensure that the conducive environment exists. Although Croatia has accomplished much in this respect, there is an unfinished agenda. The State can also, and this is holds in an incompletely privatized economy such as Croatia, help provide an orderly supply of quality financial assets, and increase the flows of financial savings that could meet this supply.

Building a Conducive Environment

4.27 Securities markets development hinges critically on an institutional framework that helps develop confidence in the safety of ownership rights and transactions, in the creditworthiness of issuers, and in the honesty of financial intermediaries. Public confidence takes an exceptional importance in Croatia, because of the distribution of shares to a majority of households. Incidence of fraud and misadministration would severely set back the process of building and sustaining the trust of an inexperienced public. To defuse these risks, Croatia is aggressively pursuing its institutional build-up in three areas: registration and transfer of securities; market oversight; and accounting and auditing standards.

4.28 Registration and transfer of securities. The currently unreliable and confused combination of corporate and CPF records of share owners is still unsatisfactory. It has proven to be prone to uncertainty and, in occasions, fraud. It is not conducive to the use of shares as a collateral, and it results in lengthy and unsafe transactions, a considerable obstacle to the development of the secondary market. The establishment of the centralized Securities Registry (SDA), which would perform depository, transfer and settlement functions, will go a long way towards solving these issues. . In mature markets, these issues are left to, and best resolved by, the private sector which is generally the main user of a Securities Registry. In Croatia, an initial role for the public sector appears to be justified because the State is still the major potential user of a Registry, and strong externalities are involved. Sheer commercial considerations, in particular, would probably lead to

78 Those instruments are tradeable only among banks. 79 Starting in mid-1996, the Treasury started issuing 45 day T-bills. Outstanding amounts are still modest (US$10 million equivalent as of September 1996). 57 limit considerably the scope of securities covered by the Registry, and fail to fully bring about market transparency and safety. This implies that, in the short-term, the Government, probably the ministry of Finance, should exercise strong leadership and coordination, including to resolve the differences which may arise among the various public agencies80 . The Securities Depository Agency (SDA) has been established with 63 shareholders, the MOF (major shareholder) and 62 market participants and banks. However, it is expected that the Registry will be privatized as soon as possible, presumably once the cost of its operations can be supported by the market.

4.29 Market oversight. Until the end of 1996, the Croatian securities markets were operating without any independent oversight. This situation was particularly worrisome and has allowed public perceptions, if not actual incidence, of unfairness and fraud to develop among current and potential investors, including foreign ones. Since the Croatian Securities and Exchange Commission (CROSEC) was established in early 1997 it has, with assistance of external consultants, completed a series of initiatives, especially in three key areas. First, the broad regulatory framework established by the Securities Law has been complemented by detailed regulations in areas such as: licensing criteria for stock exchanges, investment funds, brokerage firms and other financial market intermediaries; ethical standards for all securities markets professionals; and disclosure and auditing standards for issuers of securities. Second, market monitoring and supervision capabilities are been built from the beginning, a daunting task considering the lack of relevant experience in Croatia. Third, the CROSEC will develop, for its own needs and those of the market, training on standards and practices in financial markets (underwriting, trading, disclosure requirements, legal liabilities, ethical conduct). Demanding as it will be, this agenda for action does not reflect the main challenge faced by the CROSEC: to establish itself as credible and respected market authority

4.30 Accounting and auditing standards. The CROSEC's control over issuers of securities, and financial intermediaries, will be all the more effective that corporate financial statements can be relied upon. Croatia enacted a new Law on Accounting, and a Law on Audits, which came into force at the beginning of 1993. The former Law makes the use of International Accounting Standards mandatory. The latter introduces the concept of International Standards on Auditing, and prescribes the conditions which auditors of medium- and large-size enterprises must satisfy. While the accountant profession is already well-developed in Croatia, it may take more time until the auditing profession develops, and contributes to sound accounting practices across-the-board. While this process is typically fostered by shareholders' requests for external audits at international standards, it will also be supported by the CROSEC, and will impose similar requirements as a precondition for listing, and public offerings.

Stimulating the Supply of and Demandfor FinancialAssets

4.31. Once market security and oversight are established, most of the prerequisites to the emergence of a strong demand for financial assets will be met: the consumption-based income tax avoids any up-front taxation of financial savings; and the investment funds legislation provides

80 The Ministry of Finance, which overviews the implementation of the Securities Law and the establishment of the Securities and Exchange Commission; the Ministry of Privatization, which is to provide most of the supply of shares in the near future; the Croatian Privatization Fund, which holds records of public and privatized shares, as well as of payments of shares bought under installment payments; the Pension Fund, which is the second largest holder of shares after the CPF; and the public Payments Institute (ZAP), which currently operates all payments in Croatia. 58

suitable vehicles for household investment. The main building block still missing in Croatia is institutional investor demand, particularly life insurance or pension fund schemes that have a long- term investment horizon. While such schemes are emerging in Croatia, they may not develop rapidly because a universal public pay-as-you-go (PAYGO) pension system is already in place, and revenue and savings levels are depressed. By contrast, capital markets would receive a major boost from a reform of the pension system such as the one currently considered by the Government, (see Chapter VI). The creation of a 'second pillar', relying on savings capitalization rather than transfers from active to retired workers, would channel large amounts of savings to financial markets, stimulate the supply of financial assets, and help deepen secondary markets. Under the reform scenario discussed in Chapter VI, the annual flows of household financial savings would increase by as much as 2 percent of GDP, an extraordinary measure by past performance standards.

4.32. Pension reform-induced financial savings would not only contribute to attract new corporate issuers of securities. It would also allow, and induce 1 , the State to 'unlock', and make available to the market, the considerable amounts of financial assets -- in some cases high-quality ones -- that it still retains, and which the voucher privatization scheme will not deplete. Those include, particularly, stakes in some of the public enterprises, such as INA, the electricity and the telecommunications company. Not less importantly, the residual but significant stakes held by the CPF and the Pension Fund in many enterprises contribute, as mentioned before, to delay restructuring when needed, and more generally, the emergence of effective owner supervision. These holdings should gradually but systematically be made available to the market. Should they consistently fail to find purchasers, current owners would receive a clear signal that the bankruptcy or liquidation route is likely to be the best option.

81 In order to close the 'double-pay' fiscal gap created by the introduction of a second pillar in the pension system. PART TWO

TOWARDS A MORE GROWTH-FRIENDLY PUBLIC SECTOR

CHAPTER FIVE

A MEDIUM-TERM STRATEGY FOR PUBLIC FINANCE

5.1 The supply side policies discussed in the previous chapters are only part of the growth strategy that needs to be pursued by Croatia. Private sector-led growth is also hampered by a public sector that extracts too much from the economy. Croatia is now one of the highest-taxed Central European economies (Table 5.1) and fails to allocate an adequate share of these resources in support of growth. Pressures on public finances have come not only from the defense effort, which has consumed up to 15 percent of GDP, but also from social expenditure: as employment in the productive sector was shrinking, the public sector acted as a shelter for some of the jobless. With the recovery of real incomes, increasing dependency has overstretched public finances, driving expenditure up and, at the same time, reducing the tax base. As a result, tax-induced distortions and inequalities worsened, contributing to drive economic activity underground. Croatia now faces the threat experienced by countries with large Governments: public finances that hamper growth and, in turn, get worse because of the absence of growth.

Table 5.1: Government Expenditure and Revenue in Selected Transition Countries* In Percent of GDP

1992-94 1995 1992-94 1995

Hungary 54.9 51.2 61.4 55.2 Czech Republic 50.3 50.4 49.5 50.0 Poland 47.0 47.2 50.8 49.8 Croatia 39.1 48.8 40.2 49.7 Slovakia 45.5 47.9 52.3 47.3 Slovenia 46.9 45.9 46.8 46.2 Bulgaria 37.2 38.2 45.2 44.9 Albania 26.6 26.7 43.4 38.6 * 1995. Includes local Government. Source: World Bank

5.2 In this fiscal predicament, however, Croatia is presented with a unique opportunity. As peace is consolidated, the phasing out of extraordinary war-related expenditure offers policy-makers a one-time chance to reduce significantly public expenditure82 , and thus taxation levels, to around 40 percent of GDP. Such an accomplishment would go a long way towards stimulating the domestic savings that are needed to support private sector-led investment and growth. It can be achieved, however, only if pent-up public consumption and transfers are contained until the society's demands can be satisfied by future growth; in addition, public finances must provide enough of a stimulus to short-term growth, by supporting reconstruction and structural reforms. In the medium-term, the reduction of public expenditure would translate into lower taxation levels, which will considerably facilitate the reform and rebalancing of Croatia's tax system.

82 Unless otherwise indicated, public expenditure and revenue are those of the consolidated central Government, i.e., they include extra-budgetary funds (mainly the Pension Fund, the Health Fund and the Employment Fund) but exclude local Government. 62

Why is Croatia's Public Sector so Large?

5.3 Part of the answer to this question lies, undoubtedly, in the war experienced by Croatia, and its multiple consequences: outlays equivalent to 8-10 percent of GDP would be unnecessary in a country at peace without reconstruction requirements (Table 5.2). These include, primarily, higher spending on defense and police 83, which absorbed up to 14 percent of GDP (1995), and still more than 11 percent of GDP in 1996. In a pacified environment, 2 to 4 percent of GDP would be the norm. But other spending programs, accounting for 3-4 percent of GDP, also result from the extraordinary circumstances. These involve: (i) support to refugees and displaced persons (0.8 percent of GDP); (ii) subsidies to the railways company, which lost two-thirds of its pre-war traffic (1.5 percent of GDP); (iii) and various forms of support to war veterans (1.5 percent of GDP).

Table 5.2: Public Expenditure (1991-96)

Capital expenditure 0.8% 1.7% 1.6% 3.3% 3.9% 5.4% olw reconstruction 0.0% 0.0% 0.0% 0.0% 1.1% 1.9% Support to structural reforms 0.7% 0.7% 0.3% 0.5% 0.6% 1.4%

Defense and interior 9.0% 9.9% 9.6% 12.3% 14.0% 11.2% Subsidies 3.0% 3.3% 2.8% 2.2% 2.1% 2.0% Refugees, war veterans 0.0% 0.0% 0.0% 1.9% 1.7% 1.5%

Health (excluding cash transfers) 8.3% 8.1% 6.0% 6.0% 7.1% 7.0% Cash transfers 14.8% 10.9% 10.0% 10.1% 12.3% 13.8% otw pensions 10.1% 7.3% 7.3% 7.4% 8.9% 9.6%

memo wage bill 7.0% 5.7% 6.2% 10.0% 11.8% 11.1%

5.4 Although war-related outlays account for a large share of the budget, and deserve as such to be treated as a key 'stock' problem, they do not explain much of the recent explosion of public expenditure in Croatia (only 1.5 out of an increase of 15 percent of GDP between 1993 and 1996). Besides a welcome

These two spending items are aggregated because the war also led to an increase in police forces, and their budget. 63 increase in capital expenditure (by 4 percent of GDP), two other factors have been at play: the non-defense wage bill and social transfers, which increased by 5 and 4 percent of GDP, respectively (Table 5.2).

5.5 Whereas this increase in the wage bill and transfers parallels to a large extent the economy-wide real wage developments, the levels reached are very high, and point to a more systemic issue: the public sector has absorbed about 25 percent of the labor force lost in the enterprise sector during 1991-95 (see Table 5.3). Of course, part of this absorption was related to extraordinary circumstances (i.e., the enrollment of 150,000 soldiers in the army). But large numbers of workers were also withdrawn from the labor force through early or disability retirement, an estimated 100,000 throughout the 1991-96 period. There is also evidence of significant over-staffing in the Government civil service. The role of the public sector as a buffer to transition is illustrated by the increasing ratio of Croats living on public finances (civil servants, pensioners, and beneficiaries of unemployment benefits), relative to those employed by enterprises or self-employed (from 72 to 146 percent during 1990-95). This ratio would be even higher, 200 percent, if one were to account for those who receive no or limited cash benefits, but have access to public services such as the health care system or education. Another illustration of this phenomenon is provided by the evolution of the overall dependency ratio. While every inactive or unemployed Croatian of working age was supported by 3.9 active persons in 1990, this ratio had dropped to 1.7 by 1995.

Table 5.3: Dependency Indicators

Population 20-59, 20-55 2,462 2,452 2,453 2,459 2,466 2,468 Active in Labor markets 2,151 2,110 1,918 1,888 1,839 1,791 employed 1,956 1,826 1,657 1,645 1,591 1,542 unemployed 196 283 261 243 248 249 o1w Government 341 409 395 418 401 475 Inactive 311 342 535 571 627 677

Pensioners 633 692 762 784 813 838

'Public Finance/Enterprise' Ratio* 0.72 0.98 1.12 1.18 1.23 1.46 Ratio of employed to:

- inactive + unemployed 3.9 2.9 2.1 2.0 1.8 1.7 -inactive + unemployed + pensioners 1.8 1.5 1.1 1.1 1.0 0.9 Persons supported by public finances (civil servants, pensioners, and unemployed), divided by employees in the enterprise sector.

Source: CBS, and World Bank estimates

Is a Crisis Threatening?

5.6 In the short-term, Croatia's fiscal accounts appear to be under control. Indeed, the government has been able to increase tax revenues in parallel with expenditures, thus managing to maintain an appropriate environment for macroeconomic stability (Table 5.2). The consolidated Government deficit was limited to less than 1 percent of GDP until 1996. Even though it is expected to rise to 3 percent of GDP in 1997, this level is sustainable during the next few years because of the relatively low indebtedness level of Croati 4. However, the threat of a destabilizing crisis, in the form of an erosion of tax revenues, should not be ruled

84 The total external debt of Croatia, most of which is public or publicly guaranteed, amounts to approximately 25 percent of GDP, with domestic debt adding 15 percentage points to the public sector's debt. 64

out by the authorities. It could materialize as the private sector develops and the currently excessive tax burden stimulates the emergence of the informal sector, eventually leading to a reduction in tax collections.

5.7 Although the size of the public sector appears sustainable in the short-run, it still has a negative impact on growth because of its depressing effect on national savings, and its distortionary implications for resource allocation. National savings, and long-term growth, are likely to be depressed by the taxation levels. While economic growth rates in transition economies are initially related to the efficiency gains obtained from the implementation of structural reforms and the reallocation of productive resources (such as enterprise and financial sector reform and the acceleration of privatization), long-term growth will depend more closely on the rates of savings and investment achieved arid, consequently, on the introduction of policies that stimulate private sector development. In this last respect an important role in influencing the growth prospects of Croatia will be played both by the policy environment -- of which the tax burden and the size of the public sector are some of the components -- as well as by the quality and availability of public infrastructure to crowd-in private sector investment.

5.8 As far as distortions are concerned, the overstretching of public finances has led to a redistribution of the tax burden over fewer taxpayers and to a tax structure that increasingly distorts resource allocation. The bulk of the increase during the past three years has been generated through unreformed and distorting taxes that are a holdover of an outdated tax system. Although the Government did introduce an integrated personal and corporate income tax system in 1994, these taxes only yield a modest 4 to 5 percent of GDP. Over two-thirds of fiscal revenues are derived from partially cascading indirect taxes (20 percent of GDP) and high payroll taxes (16-17 percent of GDP), which bring with them well-known distortionary implications for resource allocation.

A Public Finance Strategy

5.9 Undoubtedly, in the medium-run Croatia needs to radically adjust its public sector in order to provide an economic framework conducive to growth. However, the time line for accomplishing such a goal is equally important. Croatia's public finances present peculiarities which may become, if the right policies are implemented, opportunities. On the one hand, the phasing out of exceptional, war-related expenditures, could yield in the next few years budgetary savings as high as 8-10 percent of GDP, the so- called 'peace dividend'. On the other hand, now that the prospect for a durable peace has become more likely, new demands are emerging: the recent large increases in social transfers reflect the society's claims for better standards of living, and the need to re-absorb large numbers of soldiers and refugees into productive activities. The risk is clear: that Croatia 'consumes' its peace dividend, rather than allocating it to the growth-enhancing spending programs, structural reforms and reconstruction, which will enable it to satisfy the society's demands in a sustainable way. These peculiar features differentiate Croatia from other transition economies and call for a two-staged approach to public finance reform:

Q During the first phase, the peace dividend should be used to finance outlays that are needed to foster private sector growth, and to start absorbing the loss of revenue that may result from the tax system reform. The pent-up trends in other large spending programs (health expenditure, social transfers) and the civil service wage bill must be contained, which will necessitate the implementation of structural reforms, discussed in Chapter VI. This phase will mostly entail switching rather than reducing public expenditure.

O As this first phase is completed, in two to three years, the exceptional requirements for growth-enhancing expenditure are reduced, particularly the core reconstruction programs, and the effects of the reforms in spending and taxation begin to be felt. A major retrenchment of the public 65

sector becomes possible, supporting the resumption of investment demand by the private sector, in the wake of the microeconomic reforms.

What are the main components of thefirst phase?

5.10 The goal during the first phase is to enable the public sector to lay the Box 5.1: Reconstruction in Croatia foundations for private sector-led growth, particularly by accommodating the up-front Reconstruction in Croatia could cost as much as 75 percent of GDP, costs of bank and enterprise reform, as well according to official estimates. The Government is aware, however, program of about as the expenditure required to rebuild of the necessity to focus on a core reconstruction ast 20 percent of GDP (see Appendix. Table 5.8), likely to generate infrastructure, demobilize soldiers, and quick returns in terms of either fiscal savings and/or output recovery. resettle refugees. Altogether, these By these two criteria, the key priority is the relocation of displaced spending programs may initially absorb an populations. mainly from Eastern and Western Slavonia, which additional 4-5 percent of GDP p.a. implies significant expenditure in housing, infrastructure and community reconstruction, and demining. Another important area is Enterprise and bank restructuring will entail the re-establishment of normal ground communications (railways and additional up-front costs of approximately highways), both within Croatia and between Croatia and neighboring 2-3 percent of GDP p.a. for the next 3 years countries. This is a prerequisite for the return of tourism to its pre- (see Table 5.4), although these costs will war levels and the normalization of domestic and international trade. ultimately be more than recovered through In sum. most spending efforts should be directed to those sectors with the greatest potential for crov6ding-in private investmenL privatization proceeds, reduced enterprise ______and bank losses, and higher economic growth. Similarly, reconstruction could rapidly generate fiscal savings of about 3 percent of GD0 5, and stimulate recovery of agricultural output and other new productive activities, but will also involve large up- front costs: an effort of 4-5 percent of GDP p.a. during two to three yearS86, significantly higher than the current 2 percent, would be highly desirable (Box 5.1).

How are these additionalcosts financed ?

5.11 Table 5.4 shows that, if the government is able to defuse a renewed surge in demands for social protection, growth-enhancing expenditure can be financed relatively easily by the 'peace dividend'. Also, some of the reconstruction programs might be accomplished through redirecting purely passive social assistance programs to others which require a more active participation on the part of beneficiaries (e.g., resettlement programs for refugees). In addition, the government could run slightly higher fiscal deficits than until 1996, in the neighborhood of 3 percent of GDP. As previously discussed, these deficit levels are sustainable if the government adopts an ambitious structural reform agenda, which will generate growth. But, because of these additional costs, the size of the public sector will remain, in all likelihood, at its current level for the next couple of years (i.e., close to 50 percent of GDP).

From the elimination of transportation subsidies (1.5 percent of GDP), financial support for displaced workers/refugees (1 percent of GDP), and other smaller programs. Croatia also needs to catch-up on the regular maintenance, and upgrading, of its infrastructure. Public investment, including health and education, never exceeded 2 percent of GDP during the 1980s. Only since 1993 has it recovered to levels between 3 and 4 percent of GDP. Not surprisingly, projects already prepared by different ministries yield a potential "need" of close to 10 percent of GDP per annum in public investment. This, however, must be balanced with the reality of scarce resources and only those projects with high rates of economic return should be pursued. 66

Table 5.4: A Medium-term Public Finance Scenario

Total Revenues 46.9% 47.5% 48% 46% 42% 40% 38% Total expenditures 47.3% 50.6% 51% 48% 44% 41% 39% Overall balance -0.4% -3.0% -3.0% -3.0% -2.0% -1.0% -1.0%

Growthf-enhancing expenditure 6 .8% 9.7% 11^4 11.3% 9 2% 7.7% 6.0%4 Capital expenditure 5.4% 6.8% 9.0% 9.0% 7.0% 6.0% 4.5% oAw reconstruction 1.9% 1.1% 5.0% 5.0% 3.0% 2.0% 2.0%

Support to structural reforms 1.4% 2.9% 2.8% 2.3% 2.2% 1.7% 1.5% olw Labor Market Policies 0.5% 0.9% 1.4% 1.5% 1.2% 0.8% 0.7% o/w Bank Restructuring 0.4% 0.7% 0.3% 0.3% 0.3% 0.3% 0.2% olw External Debt 0.5% 1.4% 1.1% 0.6% 0.7% 0.7% 0.6%

Defense & War-related expenditure 14.7% 14.3% 10.1% 7.5% 518%/ 5.3%/ 5.3% Defense and interior 11.2% 10.3% 8.0% 6.5% 5.0% 4.5% 4.5% Subsidies 2.0% 1.9% 1.4% 0.9% 0.8% 0.8% 0.8% Refugees, war veterans 1.5% 2.0% 0.8% 0.1% 0.0% 0.0% 0.0%

Social expendifture 20,8% 22.0% 21 9%/ 21.8%/ 20.8% 20.0% 19.8% Health 7.0% 7.6% 7.6% 7.4% 7.2% 7.0% 7.0% Cash transfers 13.8% 14.3% 14.3% 14.4% 13.6% 13.0% 12.8% olw pensions 9.6% 10.1% 9.8% 9.5% 9.2% 9.0% 9.0%

Other 5.6% 4.6% 7,3% 7.7% 8.1% 8.3%/ 8.3%/

* 1997 budget Source: World Bank

Are there any risks to the effective implementation of thisfirst phase?

5.12 The answer to such question is a blunt yes, particularly because the 'peace dividend' has yet to materialize, and should not be preempted by an increase in wages and social expenditure. With roughly half of the defense budget spent on wages, the reduction of defense spending implies the demobilization of large numbers of persons, equivalent to over 10 percent of the currently employed and half the officially unemployed. If adequate labor market, and social safety net, policies are not developed and funded, there will be serious pressures to slow down demobilization, and keep soldiers on the public payroll, or to force them back to their former enterprises. Like the reduction of defense spending, the savings from the resettlement of refugees will not come about without an up front investment effort. If resettled refugees and demobilized soldiers are to contribute to future growth, rather than be sheltered in the public sector or over- staffed enterprises, it is critical that Croatia design carefully, and fund adequately, comprehensive labor adjustment programs, including a combination of active and passive labor market policies, as discussed earlier. 67

What is the key goal of the second phase of the strategyfor publicfinances?

5.13 Once the foundation for private sector-led growth has been accomplished (i.e., enterprise and financial sector reform, reconstruction endeavors, and demobilization/resettlement of soldiers and refugees), a major retrenchment can take place in the public sector. This can be achieved through the progressive reduction of growth-enhancing expenditure, and further reductions in war related outlays (Table 5.4). In this context, public expenditures would eventually decrease to levels that are closer to those of Western economies, say around 40 percent of GDP. This reduction in expenditure will not only permit a commensurate decrease of tax pressure, but facilitate the completion of the tax system reform, to stimulate production and provide more appropriate incentives for labor and saving decisions. The agenda for tax system reform, whose key items include the introduction of the VAT, the reduction of payroll taxes, and improvements in tax administration, is discussed in more depth in Chapter VII. s CHAPTER SIX

HOW TO CONTAIN PUBLIC CONSUMPTION AND TRANSFERS?

6.1 The medium-term strategy for public finance relies heavily on Croatia's ability to contain durably the pent-up trends recently shown by public consumption, particularly wages, and social transfers. While Croatian policy-makers have demonstrated their ability to impose at times harsh constraints, for example on pensions in 1994-95, they have been less successful at doing so consistently, and the hard-won gains are subject to reversal. This is because the pressures on spending programs are underpinned by structural factors, mainly higher dependency of the Croatian society on the public sector, which have not been addressed. This Chapter discusses the structural reforms that should be conducted in order to contain public consumption and transfers in a sustainable way. It addresses, in turn, issues in the civil service, the health sector, and the pension system.

SECTION 1 - CIVIL SERVICE REFORM

6.2 Government spending on net wages Table 6.1: Government Employment and Wage increased by an astounding 5 percent of GDP Bill in Selected Countries (1995) during 1993-96, to reach the high level of 11 percent of GDP. These numbers would be Country Cnvil Service as a% of* Wage BJil as a % of GDP tremendously problematic in the absence of two Population Employment important caveats. First, the level of the wage bill Croatia* 9.5 34.1 11.8 reflects, in part, the exceptionally high level of Croatia* 7.4 26.7 10.2 defense expenditure, the wage component of which Hungary 8.7 24.1 7.7 accounts for about 3 percent of GDP. Yet, Czech Republic 7 14.9 4.6 assuming a reduction of defense expenditure by, Poland 5.9 15.2 8.5 say 50 percent, the Government wage bill would Slovak Republic 7.1 17.8 3.6 still stand at 10.2 percent of GDP, which remains a Slovenia 7.3 24.6 6.4 very high level by international standards (Table J* cumnt re o irn te size of military forces 6.1). The second caveat is that the recent evolution of the public wage bill is not completely out of line with that of compensations economy-wide, even though it has been somewhat faster. Average wages in the Government sector raised by about 100% during 1993- 96, as compared to about 80% in the enterprise sector. A key difference between enterprise and Government sector, however, lies in the behavior of employment over the past five years. While enterprises were able to offset part of the impact of real wages increases through the reduction of their workforce, employment in the Government sector (excluding defense and police) decreased by only 10 percent.

6.3 International comparisons suggest that Croatia should set as its objective to reduce the burden of the Government wage bill as a percentage of GDP, over and above the savings that could be yielded by the reduction of defense expenditures. Over the medium-term, a reasonable target would be to reduce the public wage bill to at most 8 percent of GDP. How can Croatia get there? Although an in-depth analysis of the public administration, and civil service system, was beyond the scope of this report, it is possible to outline two broad avenues for reforms, which should be seriously considered by the Government: wherever possible and over time, reduce public employment (i.e., increase productivity) and contain per capita remunerations while improving the overall incentive system for civil servants. 70

Improving Productivity in the Public Sector

6.4 Anecdotal evidence, and international comparisons, suggest that there may be ample room for improving productivity in Croatia's public sector. Overall, and assuming again a 50 percent reduction in the level of defense expenditure, 7.4 percent of total population, or 27 percent of employed Croats, would be on the public payroll, a level which is closer to those observed in OECD countries than in transition economies (Table 6.1). Although, again, a comprehensive review of public administration was not intended in this report, two specific examples illustrate the case for increased productivity. The first one is the deconcentrated administration at the county level (Zupanjas'), which was recently surveyed by the newly- established Ministry of Administration. The survey concluded that 3,000, out of approximately 7,500 civil servants, were redundant, and that employment levels should be reduced over time through attrition and retraining of redundant civil servants. The second example is the education sector, which accounts for some 30 percent of all public sector employees . A World Bank sectoral review conducted in 1994 suggested that students/teachers ratios, as well as weekly teaching loads, could be increased significantly without adversely affecting the quality of instruction8 8 .

6.5 Such findings suggest that there may be room for significant savings in the education, and possibly other, sectors. What should be undertaken by the Croatian authorities is: (i) a systematic review of the staffing needs of ministries and other public agencies in light of a reassessment of their missions and of productivity gains that could be achieved (e.g., through wider-scale use of information technology); and (ii) the preparation of a medium-term plan to adjust staffing needs and resources, primarily through attrition, selective hiring and retraining, and, as needed, civil service retrenchment. While the creation of the new Ministry of Administration was clearly a step in this direction, there may be a need to expand the scope of its mission as well as its resources, as a long-term investment in Croatia's public sector.

Incentives in the Civil Service

6.6 Until the public sector's productivity can be significantly increased, reducing the public wage bill relative to GDP will imply, overall, very restrictive compensation policies. The Government is well aware of this imperative, and is courageously endeavoring to impose restraint. After an unsuccessful attempt at reducing nominal civil service wages by 10 percent in 1995, the principle of zero real wage increases for the next three years has been adopted, and enforced in the FY96 budget. Such a policy, although certainly adequate from the fiscal point of view, may however prove dangerous if applied inflexibly, and in the absence of a broader framework for civil service reform. The quality of the civil service, particularly at the senior level, needs to be improved at least in selected areas. While average civil service wages are higher than in the enterprise sector, this may not be true for senior positions or for selected skills, such as finance or information technology, where the private sector is clearly more competitive.

6.7 If the Government wants to control strictly the public wage bill while avoiding a 'brain drain' in the public sector and, ultimately, improving its services, the current civil service system needs to be adapted. In order to improve incentives, and retain or attract highly qualified staff, several directions for reforms should be considered: (i) revise the compensation system in order to introduce a higher degree of discretion, and

87 Excluding defense and police.

88 Student/teacher ratios stood at 18/1 on average in primary levels, 16/1 in secondary education, and 11/1 in higher education. Research in different teaching environments suggests that higher ratios (30/1 in primary and 25/1 in secondary education) do not adversely affect the quality of education. In addition, weekly teaching loads in Croatia's education system -- 18 hours -- were assessed to be significantly lower than OECD average. 71 develop performance-based, as opposed to seniority-based, compensation; (ii) de-compress the salary scale, currently ranging only from I (unskilled employees) to 5.85 (ministers); with a limited impact on the overall wage bill, a wider salary scale has the potential of significantly improving incentives for higher level staff, and overall efficiency in the public sector; (iii) develop training in public management, either at the entry level or at mid-career, possibly through the creation of dedicated schools; and (iv) improve the prospects for a genuine 'administrative' career, by increasing the number, and enhancing the attractiveness, of senior positions in ministries (head of departments and their deputies).

SECTION 2 - REFORMING THE HEALTH SECTOR

6.8 Croatia's health care system is likely to Box 6.1: The 1993 Reforms in the Health System impose a significant burden on public finances in the years to come, unless the major reforms The 1993 reform package introduced far-reaching measures introduced in 1993 not only continue to be aimed at enhancing the efficiency of the health system and implemented, but are deepened. The 1993 reform controlling costs Tbree sets of measures were in%ol%ed. package (Box 6.1) laid the foundations for the The control of financing flows was centralized into the HI . development of a modem and more cost-effective and strengthened through the establishment of a management information system. This put an end to the overly loose system health system, and also managed to stem the inherited from the former Yugoslavia. where financial resources serious financial crisis that was developing in were earmarked to 'self-managed communities of interest. at the 1992. This crisis resulted from the insufficient local or regional level, with virtual freedom to spend adjustment Cost-control mechanisms were introduced in order to curb the of health expenditure to the prevailing pgression of expenditure. Primary care expendiure came economic conditions. As shown in Table 6.2, real under a capitation system, while secondary and tertiary care spending on health declined in real terms in 1991- expenditure became subject to annual budgets, based on a point 92, but not as fast as the resource base of the system derived from the World Health Organization Health Insurance Institute (HIll), i.e., the wage bill methodology. Also, incentiNes to shift resources to primary 89 care, away from secondary and tertiary care, were built in the in the economy : the result was a deficit of 2-3 new budgeting system. percent of GDP in 1992-93, which were covered The 1993 legislation laid the foundations of the pritalization by ad hoc measures90 , and a sharp increase in the of both the provision and insurance of health care. payroll contribution rate, from 14 to 20 percent.

6.9 By many respects, the 1993 reforms have yielded impressive results. The new budget procedures, and the management information system, have been established swiftly. The financial balance of the system has been preserved since then, albeit at the cost of higher taxation levels, relative both to the 1993 levels and to comparator countries. In addition, privatization was intended to proceed progressively, 2,000 private providers of health services -- 6-7 percent of total -- are now operating in Croatia. However, there are signs of continued tensions. Health expenditure increased significantly during 1993-96, from 6.4 to 8.6 percent of GDP, and is projected to reach 9 percent of GDP in 1997. Although part of this increase parallels the economy-wide increase in real wages, relative to GDP, wages in the health sector increased much faster than average, and other expenditure items, such as sick pay and drugs, also contributed to the pent-up trend. Croatia spends more on health than countries at comparable levels of income (Graph 6.1), for mixed results

89 Virtually all health expenditure is reimbursed by a public insurance system, managed by the Health Insurance Institute. The Health Institute is an extrabudgetary fund financed primarily by an earmarked payroll tax (14% of wages in 1995, evenly spread between employees and employers). 90 The 1992 deficit was financed by debt-to-equity swaps (1/3) and forced debt write-offs (1/3) for Croatian suppliers, and transfers from the State budget (1/3). 72 in terms of health outcomel. There are reasons to fear further pressure on expenditure, as the long overdue upgrading of health facilities is undertaken, and the provision and insurance of health care is being privatized.

6.10 The medium-term objective of Graph 6.1: GNP and Health Expenditure per Capita reducing tax pressure, and the fact that In Selected Transition Countries (1994) health expenditure has reached high levels 100 ** Sloven, by international standards, suggest that 2 500 Croatia should set as an objective to A maintain public spending on health at most 5 400 at the I996 levels, as a percentage of GDP 3oo Czech Hungary (8.5 percent). In order for the health system co to attain this objective, while continuing to 200 Slov k improve the health status of the population, 100 LTOu . * Poland three policy orientations need to be pursued A mni0l..lvi. ulaaria aggressively. First, the cost-effectiveness of 100 2000 4000 5000 6000 70`00 a a health expenditure must be improved, through more emphasis on preventive and GNP (US$ per capita - Atlas methodology) primary care. Second, cost control mechanisms should be improved, by a combined action on supply and demand. Finally, the participation of private providers and insurers of health services should be encouraged, but at the same time be carefully regulated.

More Cost-effective Spending

6.11 That Croatia spends more on health than countries at similar income levels, with no obvious impact on the health status of population, suggests that there is room for improving the cost-effectiveness of spending, through reallocation in two directions.

6.12 First, much greater emphasis should be placed on public health programs. Such programs, aimed at developing prevention and health-promoting behaviors, involve much lower costs and have been proven to have a much higher payoff than higher spending on health care. While vaccination programs have been successful at stemming infectious diseases, Croatia is now confronted to the typical health problems of a mature middle-income economy, dominated by chronic degenerative, and lifestyle-related, diseases. Too many people still unnecessarily die from, or are impaired by, accidents or illnesses that could be prevented or delayed. The solution to this problem lies not in more expensive health care services, but in a combination of actions involving a cross-section of sectors: education of the population and health providers; public awareness campaigns; food standards and information; industry and environment; taxation; and local government. Recent increases in tobacco tax, the banning of advertisement on tobacco, and the prohibition of smoking from public places, were very positive steps. But there is a need to develop more

91 Life expectancy for women (75 years) lags 4-5 years behind that of OECD countries, but is close to the average for transition countries. Men, on the other hand, die on average at around 65, i.e., 8 years and 4 years earlier than in OECD and transition countries, respectively. The rate of infant mortality (9.6 per thousand) lags behind OECD countries but is the third lowest in former socialist countries. The high level of abortions -- 74 for 100 live births in 1992 -- is partly a consequence of the limited development of contraception and remains an important threat to women's health. 73 comprehensive and aggressive policies, and to increase significantly the resources devoted to public health in Croatia, which are at present symbolic.

Table 6.2: Expenditure and Revenue of the Health Insurance Fund

in%ofTGDP Health Care 7.6% 6,4% 5.7% 5.8% 6.7% 6.5% 6.7% Primary & dental care 1.7% 1.1% 0.9% 1.0% 1.2% N.A. NA. Polyclinics 1.2% 0.9% 0.8% 0.7% 0.8% N.A. NA. Hospital care 3.1% 2.4% 2.0% 2.2% 2.8% N.A. N.A. Drugs 1.1% 1.4% 1.4% 1.3% 1.4% N.A. N.A. Other 0.4% 0.6% 0.6% 0.5% 0.5% N.A. N.A. Cash benefits 1.6% 0,4% 10A4% 0.8% 1,2% 1.6% 1,6% sick pay 1.0% 0.2% 0.1% 0.3% 0.5% N.A. N.A. maternity 0.5% 0.2% 0.2% 0.4% 0.5% NA. N.A. Other 0,J% 1.7% 0.4% 0.2% 0.3% o.5%4 0%

Total expenditure 9.8% 8.5% 6A4% 6.8%/ 8.2%*/ 8.6% 9,1%A Revenues 7.8% 5.7% 5.9% 7.0% 8.0% 8.4% 9.0% Bane-2Z0% -2.8% -).6% 012% -0.2% 40.2% -0.1% *budget

6.13 Second, the role of primary care should be signficantly reinforced in Croatia. Not only can primary care reduce costs by avoiding unnecessary use of more expensive secondary and tertiary facilities, but it could also contribute to the implementation of prevention programs. This was an explicit objective of the 1993 reforms, which tried to give physicians financial incentives not to refer their patients to specialists or to hospitals. Actual results, however, have been disappointing: in 1995, primary care accounted for only a low 14.6 percent of total health care expenditure, the same share as in 1993; by contrast, hospital expenditure increased its share in total by 3 percentage points. While the financial incentives given to physicians may be too low to modify behaviors, and do not address in any case the patients' incentives, an additional problem may result from an inadequate supply of primary care services, particularly ambulatory back-up services (X-ray, laboratories and para-medical staff). In light of the limited results obtained so far, the health authorities might want to consider more aggressive measures to help increase/improve the supply of primary care services, including by facilitating the shifting of resources away from the secondary and tertiary levels, for instance: (i) modify incentives for patients, through higher co-payments on secondary or tertiary services; (ii) rebalance remuneration levels in favor of selected medical services offered at the primary level; (iii) retrain providers operating at the secondary or tertiary levels, and possibly provide financial incentives for them to shift to primary care.

Better Cost-control Mechanisms.

6.14 Although the budgeting systems developed since 1993 constitute a radical transformation from past practices, and have yielded results, they have not been as effective as could have been hoped for. Based on the past two years' experience, three areas of reform deserve particular consideration: the relationship between the health authorities (i.e., the Ministry of Health and the HII) and the budgetary authorities; budgeting mechanisms; and the issue of demand for health services. 74

Budget Approval and Control

6.15 The degree of control exercised by the budgetary authorities over the extrabudgetary fund 9 2 is much looser than in the case of the central Government expenditure, for three reasons. First, under current procedures, the Parliament does not vote a binding budget for them, but merely approves past and projected financial statements which are annexed to the general budget, but not part of it. Second, the Ministry of Finance lacks the skills which would be indispensable to effectively counterbalance the technical expertise of the extrabudgetary funds' management. Finally, the problem is compounded by the earmarking of revenues for extrabudgetary fund expenditure, which acts as an invitation to spend all the resources collected, and/or reduces the incentive to collect revenue. This is, clearly, the lesson of the wage increase episode of 1994-95, which boosted HII's revenues, and amounted to a serious weakening of financial discipline. While these problems are theoretically common to all extra-budgetary funds, they become critical when spending decisions are extremely decentralized, as is the case in the health sector, as opposed to social transfers which are determined by discrete decisions (e.g., increasing pension awards). If financial discipline is to be restored in the health sector, the message must be sent unequivocally that no public agency is entitled to spend freely a fixed share of national revenue or, in the present case, of the wage bill. The budget procedure should be modified to have the Parliament vote annually a binding ceiling on the expenditure of the HII, not on its revenues. The rate of the payroll contribution should also be explicitly approved annually by the Parliament, and allowed to decrease, particularly if wages have increased faster than GDP. Finally, developing in-house expertise on health economy and finance in the Ministry of Finance would help improve the rationality of budgetary decisions in this area, as well as the accountability of health authorities.

Budgeting Mechanisms

6.16 While these measures are necessary to reinforce the HI's accountability, they will bear fruit only if the existing cost-control procedures are revisited, and tightened when needed. The situation varies widely according to the functional areas of spending.

6.17 Primary care does not appear to be an area of major concern. The capitation system established in 1993 provides, in principle, a good way of capping expenditure while stimulating efficiency in service delivery (patients can switch physician once a year). Over the past two years, remuneration levels appear to have been adjusted at or below general wage increases. If anything, in light of the desired emphasis on primary care, capitation levels could be allowed to increase faster than specialist remunerations, within the overall limits set on the overall budget.

6.18 Hospital expenditure is more of an issue. Although the governance of health facilities was improved in 1993 , and the 1I has the option of replacing hospital managers who do not meet their budget targets, budgets themselves are neither binding nor perceived as so9. With cash benefits (see next

92 The HII is one of several extra-budgetary funds, which also include the Pension Fund, the Unemployment Funds, and the Children's Fund. All Extrabudgetary Funds are financed through earmarked payroll taxes.

93 Hospital management is overseen by a Board with representation of the local Government, the HIF, and health practitioners). 94 Hospitals are subject to an annual budget that is calculated based on: (i) the number of beds, and the expected occupancy rates; (ii) the projected amount needed for drugs; and (iii) the projected amount for reimbursement of services, based on a point system. The cap is not binding, but hospitals which exceed them are examined and a 75 paragraph), the hospital sector is mainly responsible for the increase in health expenditure since 1993 (see Table 6.2, and Graph 6.2). As seen in the Czech Republic, the points system may lead to cost escalation in the absence of careful monitoring and balancing of health care and costs. It may, in particular, create perverse incentives to perform, or claim, a higher number of more specialized -- and lucrative -- procedures than necessary. The health authorities may want to consider the following additional measures:

* Start developing, as a matter of priority given the delays involved, evaluation procedures allowing managers -- and the central level -- to measure the effectiveness of clinical protocols or staff performance, identify cost centers or match the costs and benefits of medical procedures.

* Should the recent upward expenditure trend continue, consider substituting to the point-based system global budgets, that would increase by a fixed percentage annually, safe for predefined structural changes. Hospital managers should become fully accountable for meeting their budget targets and, correspondingly, be granted greater autonomy to run their facilities, for instance hire and fire staff, or develop performance-based compensation systems.

6.19 Cash benefits (mainly sick pay and maternity benefits) skyrocketed during 1994-96, increasing more than fourfold in real terms, from .4 to 1.6 percent of GDP (Table 6.2). The escalation of sick pay, five times in real terms, was particularly spectacular. To a large extent, however, the increase in cash benefits was a 'catch up' on the 1992-93 period, when they had dropped faster than average. These Graph 6.2: Main Components of Health trends nevertheless call for close attention from 3 Expenditures policy-makers, if one is to ensure that the burden of cash benefits on public resources be 30% at most contained at current levels. The main issue appears to lie in the structure of sick pay n, 2.5% benefits, which provide little incentive to return 0 to work, and may even be used as a substitute '0 2.0% for labor market-adjustment measures. M :: .% 6.20 Sick pay benefits amount to 80 percent . 0% of wages (as opposed to 50 percent for + +

unemployment benefits until recently), and can 0.5% be served as long as sickness is medically certified, without reduction over time (whereas 0.0% . . 1 unemployment benefits are paid for one year on 1991 1992 1993 1994 1995 -K - Primary & dental -+ - Polyclinics average). Although the cost of sick pay is ---- Hospital care --- Drugs borne by the employer for the first 42 days, a -- 0- cash benefits provision which should act as a major disincentive for them, it is probably all too tempting for employers and employees to collude in order to have the HII finance temporary or permanent unemployment. The temptation is probably heightened by the fact that sick benefits are paid directly into the hands of employers, who had also, until recently, the opportunity to increase at little cost for them the benefit base (the last wage paid). Workers may also be unnecessarily deterred from accepting part-time jobs, due to overly rigid definitions used by the HII. In order to try and stem the escalation of sick pay benefits, the health authorities recently (early 1996) extended

determination is made of the causes of excess spending. The hospital may either receive an additional budget, or be subject to sanctions, including the replacement of the manager. 76

to six months the reference period used to calculate benefit levels, and established financial sanctions for complacent physicians (reduction in capitation payments). These measures might prove insufficient, however, and the authorities might then have to consider one or several additional steps: (i) reduce the replacement ratio at or below the formula used for unemployment benefits; (ii) extend the 'deductible period beyond the current 42 days and, possibly, allow employers to require that workers finance all or part of this longer period, for instance from annual leave; (iii) limit sick pay to a period of, say six months, following which the recipient could apply for temporary disability payments (and job retraining) or a permanent disability pension; the decision should be made by a reconfigured medical review board that balances the legitimate interests of the patient, the HII and the Pension Institute; (iv) make sick benefit payments directly into the hands of beneficiaries; (v) improve incentives to return to work, particularly through increased flexibility in the definition of part-time work.

The Demand Side

6.21 Health costs are unlikely to be contained in the medium-run if supply side controls are not supplemented by measures to moderate the demand for health services. The introduction of, or increase in, co-payments can help achieve this objective while reducing public costs. At present co-payments are quite limited in Croatia, and account for only one percent of HII's revenues. An estimated 25 percent of the population is exempted95. The authorities should seriously consider a significant increase in the level of co- payments, and their extension to the whole population, with exceptions justified by revenue considerations only. The level of co-payments could be modulated to encourage/deter demand according to policy priorities. For instance, co-payments may not be warranted for primary care services, given the need to promote them and the control of costs through capitation, while they should be increased/established for secondary or tertiary care.

Privatization in the Health Sector

6.22 The privatization of the provision, and insurance, of health services, can play an important role in enhancing the efficiency of the public sector and increasing overall consumer satisfaction. However, international experience demonstrates that, if not carefully regulated, privatization may also have serious drawbacks, for instance undue transfer of costs to the public sector, or the development of a dual health system, serving the needs of the wealthier and the poorer under widely different quality standards. Special attention should be paid to the implications of privatization in Croatia, and to the preparation of a sound regulatory framework, particularly regarding the following issues:

* The qualification of private providers and their relationship with the public insurance system should be carefully defined. High reimbursement levels and small co-payments may lead to an escalation of costs, especially when care is delivered on a fee-for-service basis; on the other hand, low reimbursement levels may lead private practitioners to refuse contracting with HII -- as has been the case with most of the 700 privately-established dentists, and to be unaffordable for many patients.

* Private providers should not be allowed to thrive at the expense of public finance. Typically, the problem arises when practitioners are allowed to provide private services in public hospitals. It is unclear, for example, whether the use of premises and medical equipment is adequately

95 In addition to low-income households, exempted groups include children under age 15, pregnant women, those with infectious diseases, displaced persons, disabled persons, and frequent blood donors. 77

charged in such cases. Another possible source of abuse lies in a provision of the 1993 legislation, which calls for the HII to purchase equipment for lease to private providers.

* Finally, the unregulated development of private insurance schemes may lead, particularly since the possibility of 'opting out' of the public system is open, to 'cream-skimming', or biased customer selection based on risks and revenues. The risk would then be high for the. public insurance system to be left with the 'bad' risks, while suffering a significant erosion of its revenues. The perception of these risks led the Health authorities to suspend the implementation of the opt-out clause, and the operations of the first private insurance company. While belated caution is better than none, the review of the implications of private insurance, and the issuance of new regulations, should now be accelerated.

SECTION 3 - REFORMING THE PENSION SYSTEM

6.23 Croatia's pay-as-you-go (PAYG) pension system is subject to severe strain, a situation best illustrated by two contrasting developments: on the one hand, pension expenditure increased from 7 to almost 10 percent of GDP during 1992-96; on the other hand, the level of old-age pension awards, expressed as a percentage of average net wages96, declined from about 90 percent in 1988-90 to 50 percent in 1995; and real pensions, in spite of a 30 percent increase since 1993, stand at 60 percent of their 1990 levels (Table 6.3). With the return to peace, the pressures for a 'catch-up' of pensions on past levels, or past replacement rates, are increasing, and could have a major impact on public finances.

6.24 Assuming unchanged wage levels, a recovery of replacement rates less than half-way to their level in the late 1980s, such as 60 percent, would cause pensions to absorb an additional 3.5 percent of GDP, and payroll contribution rates to shoot up from 20.5 to 28 percent. A mere 10 percent increase in real pensions, over and above the growth of GDP, would cost 1 percent of GDP.

Box 6.2: Croatia's Pension System

Croatia's pension system is a pay-as-you-go financed, defined benefit, public scheme. It includes three self-contained funds, each depending solel% on its own resources- the Workers' Fund, the Farmers' Fund and the Self-Employment Fund. In practice. the three Funds operate as a single extra-budgetary entity.

The Workers' Fund accounts for 90 percent of the three Funds' retirees and expenditures, and therefore drives the dynamics of the whole system It is essentially Financed by a 25.5 percent tax, levied on total wages and equally borne by employees and employers (95 percent of revenues). The effective rate, however, is about 20 percent, as the Pension Fund transfer about 5.5 of payroll to the Health Insurance Institute. to finance health care of retired persons. Other revenues include transfers from the State budget (3 percent of total in 1995), and dividends from the share portfolio transferred to the Pension Funds (1.5 percent of total).

Retirement ages (with full pension) are 60 for men and 55 for women. Before the new Labor Law of 1995. credits for early retirement could be purchased, up to fi%e years. In addition, 'merit pensions have been awarded to retired military and other special groups, and there is a means-tested minimum pension level. Since early 1994, post-retirement adjustments have no longer been automatically tied to general wage increases. but made on an ad hoc basis, by Government decree. Contributions for pensions are deductible from the income tax base, while benefits are taxable - although most pensioners are below the entry threshold for income tax liability.

96 The average pension benefit (including old age, survivor and invalidity pensions) divided by average wages, net of employees' contributions and income tax. 78

6.25 The spectacular deterioration of the pension system's performance was not primarily due to the aging of Croatia's population. In fact, the 'old age dependency ratio' (the proportion of persons older than 60 decreased only slightly during 1990-95, from 2.97 to about 2.66 (Table 6.3). Demographic projections indicate that it will remain roughly stable until 2010, and then increase sharply as a result of the post-war cohorts' starting to retire.

6.26 What is much more striking is the deterioration of the 'system dependency ratio' --the number of pension beneficiaries, relative to contributors-- over the past five years. While every active worker was supporting on average .35 pensioner in 1990 --a proportion that had remained broadly stable for over 20 years-- this proportion had climbed to .58 by 1995, one of the highest in the world, and far out of line with Croatia's age structure. Had the 1970-90 trends continued, the system dependency ratio would have been expected to increase to only .36. What caused the faster-than-predicted deterioration was the massive shrinking of employment during 1991-95, combined with overly liberal retirement policies. Not only are 'regular' retirement ages relatively low by Western countries' standards, especially for women (60 and 55 for men and women, respectively), but early and invalidity retirement were generously allowed until 1995, and extensively used as a substitute to adjustment in market labor f. The two phenomena -- the shrinking of the labor force and the 'abnormal' shift from contributors to beneficiaries -- explain 60 and 40 percent, respectively, of the difference between the predicted - .36 - and the actual - .58 - system replacement ratio.

Reforming the Pay-as-you-go System

6.27 The Croatian authorities should endeavor to reduce the burden of pensions both as a percentage of payroll and as a percentage of GDP. As will be discussed in more depth in Chapter VII, the overall burden of payroll contributions is already high, and has negative microeconomic effects, on labor markets and international competitiveness. The rationale for reducing pension expenditure as a percent of GDP revolves around the need to increase domestic savings in Croatia: as pensioners are likely to have a higher propensity to consume than wage earners, a higher share of pensions in GDP implies more consumption, and less private or enterprise savings.

6.28 Past policies have not been successful at meeting these objectives. As mentioned earlier, the burden of adjusting to a higher system dependency ratio was borne mostly by pensioners, in the form of lower wage replacement rates, but payroll contribution rates also increased , and some -- limited -- deficits were incurred99 . The erosion of replacement ratios resulted, until 1993, from inflation adjustments that lagged behind those of wages. As part of the 1993 stabilization package, the Government decided to discontinue

Under a special scheme, enterprises were allowed to purchase, at advantageous conditions, early retirement credits for their workers, up to five years. The number of additional pensioners due to early retirement is estimated at about 100,000, or 20-25 percent of the jobs lost during the period. This practice was discontinued in 1994. Early retirement remains possible under current pension regulations, but involves a reduction of pension levels. 98 Effective payroll contribution rates (the overall contribution rate for pensions, netted from transfers to the Health Insurance Institute -- see Box 6.2) increased from 18.5 to 22 percent in mid-1991, and were reduced to 20.5 in 1995. 99 Deficits fluctuated between .2 and .7 percent of GDP during 1991-94, and were financed by a drawdown of reserves, and some limited use of the privatization assets transferred to the Pension Fund: dividends paid by enterprises, and assets sales, either direct or indirect (collateralized borrowings that cannot be repaid, in the Pension Fund's present financial condition, without disposing of the collateral). Only in 1995 did the situation worsen somewhat, with the deficit increasing to .9 percent of GDP and the date of pension payment slipping by two weeks. 79

automatic indexation of pensions, and to proceed with one-time adjustments. During 1994-96, the real increase of pension awards -- 30 percent -- was only one-third of that of real wages: the continued decline of replacement rates offset the deterioration of the system dependency ratio, averting an increase in the payroll contribution rate. However, real pension increases exceeded by far the pace of economic growth during the period, resulting in higher pension expenditure as a percentage of GDP.

6.29 The Government has taken steps to prevent further deterioration in the pension system's equilibria. The purchase by enterprises of credits for early retirement was discontinued in 1995. The Pension Fund also moved to control the growing cost of disability pensions. A six-month waiting period has been imposed, and central supervision of the regional offices that determine disability claims has been heightened. While these measures may help prevent further worsening of the pension system's dependency ratio, they will not reverse the deterioration that took place during the past five years. In the short-term, the only way to reduce pension expenditure, as a percentage of payroll and of GDP, is to limit pension adjustments to the rate of inflation. Assuming GDP growth of 5 percent p.a., implementing this policy could generate savings of about 2 percent of GDP after five years. Whereas this policy may be politically unpalatable, it should be borne in mind that the current replacement ratios may be low by Croatia's pre-war standards, but not by international standards. In other words, with less active workers and more retirees, Croatia can no longer afford to be more generous than other nations if it is to compete internationally.

Table 6.3: Key Indicators of the Pension System .1988T 199 90 99 99 993 1994 19

Pension Expenditure as a % of GDP n.a. n.a. 9.9% 10.1% 7.3% 7.3% 7.4% 8.9%

System Dependency Ratios: - Insured to Pensioners 3.2 3.08 2.83 2.41 2.02 1.93 1.83 1.73 - Pensioners to Insured 0.31 0.32 0.35 0.41 0.50 0.52 0.55 0.58

Age Dependency ratio* n.a. n.a. 2.97 2.89 2.83 2.77 2.71 2.66 Real Pension Benefits (1990=100) n.a. 100 102.4 79.7 49.5 47.2 50.0 60.7 Net Replacement Ratio* 90.2% 91.0% 88.7% 74.2% 73.6% 71.4% 60.6% 50.5%

20-60 year-old, over more than 60 year-old average old-age pension as a percentage of average net wages

6.30 Over the medium-term, however, there is a possibility to partly reverse the deterioration of the system dependency ratio, and generate additional savings over current pension spending. This possibility would materialize if the Government were to implement the pension system reform currently being considered. Reflecting increasing longevity, retirement ages would be progressively brought to 65 and 60 for men and women, respectively, from the current 60 and 55100, and the decrement for early retirement would be corrected to ensure actuarial fairness. In addition, the pension formula would become based on lifetime earningsl0 1 , instead of the current best 10 years. These policy measures have been adopted, or are considered, by most pension reformers in Central and Eastern Europe. Their positive effects, however, will

100 At the rate of an additional six months contribution period per calendar year. 101 Initially, from 1970 onwards (for wage data availability reasons). 80

materialize only progressively because many in the groups potentially affected have already retired. The system dependency ratio would decrease gradually from .58 to about .42 by 2010, and catch up on current levels by 2035, as a result of the aging of the Croatian population. Implementing these reforms can also generate additional savings over current spending on pensions. The implicit payroll contribution tax could be allowed to decrease from the current 20 percent to about 17 percent by 2000, and 15 percent by 2010. This would also allow Croatia to reduce spending on pensions by about 1 percent of GDP by 2000, and 2 percent of GDP by 2010, over and above the savings that could result from 'inflation only' adjustment policies.

Moving to a Multi-pillar System

6.31 As discussed, tightening the eligibility criteria of the current PAYG system would generate savings increasing progressively to 2 percent of GDP p.a. by 2010. Nationally, these savings could be allocated to improve pension levels, reduce contribution rates, or finance alternative Government consumption or investment. Another option, recommended by this report, would be to use the space gradually opened by the reform of the PAYG system to finance, over the medium-term, the costs that would be associated with the introduction of a mandatory fully-fundedl 02 element (or 'second pillar') in Croatia's pension system. Box 6.3 explains the rationale for such an option.

Designinga Two-pillar System

6.32 Careful design and implementation of the transition to a multi-pillar system lie at the core of a successful pension reform. The new system should be able to generate some efficiency gains, even in the transitional period, and at the same time prove acceptable from the fiscal point of view. This is not an easy task, as an aggressive reform strategy may stretch public finance in the short term beyond an acceptable level, whereas an excessively gradualist strategy may yield very few benefits in the first years of implementation, or be reversed.

6.33 An aggressive strategy could involve transferring all workers to a new fully-funded pillar which would receive, say, half of current contributions, while also honoring current pension obligations and the accumulated entitlements of current workers to future pensions. The Government would face a financing problem, as payroll contributions would be reduced from about 10 to 5 percent of GDP, and no longer cover the PAYG system's current expenditure. To finance both pillars and avoid an unbearable burden on wages, the Government would have to resort to general taxation, and/or accept a much larger fiscal deficit and finance it through bond issues. Both solutions at the required scale could prove problematic. General tax finance would contribute to perpetuate the high tax burden, increase marginal tax rates, and efficiency gains would therefore be questionable. On the other hand, massively increased supply of Government bonds, although it could in principle be partly matched by demand from the new Pension Funds, could prove unfeasible, or introduce an element of risk in the perception of investors and complicate sovereign debt issues.

6.34 At the other extreme, a gradualistic strategy would avoid adding the short-term fiscal burden, and introduce the second pillar after sufficient savings have been generated from the PAYG system reform. A

102 Under a 'fully-funded' approach, pension liabilities are fully 'funded' by financial or real assets, that are purchased as contributions are being made, and not by claims on current workers. The transition to a fully, or partly, funded system therefore creates a 'double pay' problem: current workers' contributions are no longer available to fund the liabilities of current retirees. 81 reduction of contribution rates to about 15 percent would indeed allow the introduction of a second pillar without large initial deficits or increases in the contribution rate. However, it would take about ten years for the PAYG system reform to yield the required savings, which could in the meantime be preempted to increase current benefits.

Box 6.3: Why introduce a second pillar in Croatia's pension system ?

Recent research on pension sstemsl03 suggests that the introduction of a fully-funded element in a pension system. besides a PAYG pillar that would be down-sized accordingly, could yield three major benefits:

* First, the objectives of interpersonal redistribution/insurance, and intertemporal savings, which are often combined within a PAYG s stem, can be better and more clearly achie%ed by different schemes each pursuing one single objective B% linking closely contributions to benefits for each individual. a fully-funded 'pillar' would be perceived clearly as a vehicle for personal savings. rather than a tax, and would incidentally eliminate compliance issues It would also alleviate the tensions that will result from the aging of the population, 20 years from now. A - down-sized - first pillar' would be allowed to pursue more redistributional objectives, linking more loosely contributions and benefits (e.g., a minimal flat benefit). while keeping what is percei%ed as a'tax' levels within reasonable limits.

Second. the introduction of a second pillar could increase the overall rate of domestic savings, although the increase in second-pillar savings might be offset by a reduction in other forms of savings. It would, in any case. boost the flows of savings intermediated through the financial system, and would therefore be likely to help accelerate the build up of capital markets in Croatia. Increased savings or financial savings. and a more efficient finEncial system, are also likely to increase the volume and improve the allocation of investment, and therefore future potential GDP. Although the eventual 'contribution' rate could be the same under a pure PAYG system or a two-pillar system. the latter policy will have increased to a larger extent domestic wealth, making it easier to allocate consumption between the then-retired and working populations.

* Third. a multi-pillar system would diversify the 'systemic' risks inherent to a pension system. in two ways. Economically. it would di%ersify the claims that fund pension liabilities, away from the tax base to the economy at large. Politically, some of the intermediation between generations would be allowed to take place through financial markets, thus lessening demands that have to be negotiated through the political sector.

While the above fully applies in Croatia, there are even more compelling reasons to introduce a multi-pillar system.

* First, as already discussed, the need to increase savings and investment is more acute than elsewhere. while financial markets are also at an earlier stage of their development.

* Second. given the large deterioration of the system dependency ratio, a partially capitalized system offers the potential of higher overall rates of return A reformed PAYG system would settle into a 57 percent replacement rate equilibrium in the long-term. In a two-pillar system with 5 of the 20 percent contribution rate initially going to the second pillar, long-term replacement rates would be higher (60 percent) if returns on investment are only I percent higher than real wage growth. Should real interest rates be 3 percent higher than real wage growth then long-term replacement rates would be as much as 70-80 percent. The latter scenario likely would translate into individuals being able to retire earlier

* Third. developing a partially capitalized system could speed up the divestiture of the share portfolio currently held by the Pension Funds, and yield additional efficiency gains economy-wide.

6.35 An intermediate solution could involve a partial but irreversible switch to a fully funded pillar, the parameters of which would take into account future PAYG savings, and the possibility to fund part of the transition costs with privatization assets. Under this solution, all workers under a cut-off age, say 40 years, would be forced to direct half of their own and their employers' contributions to the second pillar, amounting

103 Including a leading World Bank publication: 'Averting the old age crisis', The World Bank, 1994. 82 to 4-5 percent of total payroll, or about 2 percent of GDPl04. They would be entitled, regardless of their contribution history, to a semi-flat first-pillar pension replacing 30 percent of net wages. The fully funded component would provide a pension replacing another 35 percent of net wages.

How to Financethe Initial Transition Costs?

6.36 As discussed earlier, any transition to a partially funded system inevitably encounters the 'double pay' burden, that is, the need to finance both existing commitments to pensioners and older workers, while channeling part of the contributions to the newly established private, pension funds. This double pay burden can be lessened by generating budgetary savings through reforms in the PAYG system and using budgetary revenues resulting from the privatization of state assets which generates revenues for the public sector which, in an accounting sense, are "below the line" revenues.

6.37 It is important to separate the issue of pension reform from the issue of privatization of state assets. The pension reform converts an "implicit debt," i.e. an implicit government obligation to future retirees, into an explicit debt. Although the general government runs an increasing budget deficit as a result, this is exactly offset by the increase in private savings that arises from the surplus in the private pension funds and therefore does not, per se, increase the national savings rate. An increase in national savings can only be expected if the pension reform is financed in ways that encourage higher savings and capital formation. Reducing public expenditures linked to pension benefits as a result of reforms in the PAYG system, and thereby reducing government dissavings, is one such way. Another way to encourage higher national savings is to allow the newly created pension funds to invest in profitable ventures while avoiding excessive risk exposure. The preferred approach is to allow the new pension funds to make their own portfolio decisions regarding the type of investment they want to make, based on guidelines issued by the agency which regulates their activities. Constraining the private pension funds to hold equity in privatized companies is not an optimal way to manage retirement savings. Moreover, it may introduce undesirable distortions in the new ownership and governance arrangements of newly privatized enterprises.

6.38 In the short term, however, the challenge is to finance the transition gap between the start of the new system, say in 1999, and the time when the combined effects of better compliance and increases in the retirement age take hold. Given all the constraints, the only practical solution is to use the privatization assets allocated to, or designated for, the Pension Funds for the purpose of pension reform.

6.39 Using the privatization assets to finance part of the initialtransition costs As explained in Chapter II, about 15 percent of the equity of the socially-owned enterprises, equivalent to about US$2 billion, were transferred to the Pension Funds. Initially, the hope was that these assets might produce enough income to allow for a resumption of full post-retirement indexing and/or higher initial benefit levels. This hope has not been realized, nor was it realistic from the start. The value of the Pension Funds' assets was equivalent to about one year of pension spending. Under the best of circumstances, income from this portfolio could not have been expected to exceed five percent of annual spending. In 1995, it actually stood at 2.1 percent of total spending on pensions, also suggesting that the underlying asset portfolio was significantly overvalued.

104 There are several pragmatic reasons for this bifurcation: (i) only after 20 or more years of accumulation do the assets in the second pillar accounts begin to generate significant annual income; (ii) the entire amount of the contribution rate for those above the cut-off age continues to flow to the PAYG scheme, thus keeping the effective contribution rate higher in the critical initial years; (iii) not requiring older workers to join the two-pillar system minimizes disruptions in expectations among the population that has the most invested in the current PAYG arrangements. 83

6.40 Not only does the Pension Funds' ownership of a large portfolio improve little its operating cash flow, but it is seriously questionable from an efficiency point of view. On the one hand, the Funds as Government institutions are not in the position, no matter how 'independently' they are managed, to demand that enterprises downsize, divest themselves of non-core businesses and otherwise increase shareholder value. On the other hand, the Funds' holdings are often significant as a percentage of some companies' equity, and can contribute to delay the much-needed consolidation of their ownership structure, and the emergence of a more effective governance. By many respects, an optimal solution would therefore consist of using privatization assets to finance part of the initial costs of the transition to a multi-pillar pension system. Assuming that the market value of the Funds' portfolio is about 50 percent of book value (as suggested by the actual rates of return), these assets would be worth 5 percent of GDP, and could cover 2-3, out of 6-7, years of transition. Should 30 percent of the equity of the large public enterprises be used for pension reform purposes, as stated in the new Privatization Law, the outlook would be even better. The Pension Funds' share in public enterprises would amount to an estimated 10 percent of GDP, and could cover another 5 years of transition. At this point, the savings generated by the first pillar reform would be sufficient to cover the costs resulting from the introduction of the second pillar.

6.41 Whereas using privatization assets to finance the costs of transition has much appeal, implementing this concept is more difficult. Two alternatives have been suggested. The first one would use those assets to directly capitalize second pillar pension funds. The second would involve the sale of the privatization assets on the market, with the proceeds reverting to the State budget to fill -- with-a possible time lag -- the fiscal 105 gap

6.42 Direct Conversion Approach. Under the first approach, the privatization assets available for pension reform would be used directly to 'fund' the second pillar accounts. The assets would be bid out among a set of investment managers, who would have to put some of their own capital at risk (for example, 10 percent of the assets), and would be further required to keep the profile of their 10 percent holdings the same as the remaining ninety percent. The mutual fund managers would then be expected to begin trading among themselves and others, developing portfolios with different styles.

6.43 After, say, three years, the underlying enterprises in these mutual funds should have more established prices and, accordingly, so also these mutual funds. The participants to the second pillar would convert three year's worth of accumulation in their notional accounts into shares in these second pillar mutual funds. For roughly another four years, workers' second pillar contributions would go to purchase the Pension Institute's remaining ownership of these mutual funds. By this means, the Pension Institute's PAYG gap would be filled. After all the Pension Funds' shares in the mutual funds have been transferred to the second pillar accounts (hypothetically, by the end of year seven), the workers would have to choose where to invest their future second pillar contributions.

105 Under both approaches, however, the new second pillar accounts might remain 'notional' for the first 1-3 years (i.e., the assets in the accounts would be nontradeable government debt earning a market interest rate). After the initial period, the accounts would be converted to assets in designated second pillar pension funds. The reasons for this initial period are twofold. First, regardless which approach is followed, the designated second pillar fund asset managers have to be chosen, the supervisory agencies must be formed and staffed and regulations prescribed. Second, if the other endeavors ongoing in Croatia are successful, a firmer price will have been established for the assets available for pension reform. During this initial period, the 5 percent of payroll designated for second pillar accounts would go directly to the Pension Fund to finance existing payments. 84

Box 6.4: Technical Issues of Second Pillar Reform

Investmeni zuidelines for second pillar accowns. Owners and managers of second pillar accounts must be gi%en the greatest possible degree of freedom in choosing their holdings In the sell-off approoch, this will have to faced fully at the time individuals are allowed to shift out of their notional accounts. In the direct conversion approach. the question occurs earl on with respect to 10 percent of their accounts and fully after the consersion proc,:ss is completed. TypicallN, prudent policies would rule out investment in real property, stock issued in Croatia with less than AAA status. corporate bonds issued in Croatia niahout bank guarantee, and derivatikes; instead. the second pillar accounts would be allowed to be in%ested only in authorized mutual funds. achieing greater risk dikersification

Government Guarantee of Second Pillar Investments A go%ernment guaraniee of the second pillar accounts should be a%oided. as it would be likely to either create significant moral hazards, or leid to considerable regulation by govenrmeni authornties The need for a guarantee, how%ever. may be politically una%oidable in order to ensure that the first pillar benefit le%el is sufficient along with a 'ery low return on second pillar in%estments, to yield minimally adequate incomes Many have argued that the 'relative' rate of return guarantee in Chile and Argentina have been harmless and helped reassure participants.

Im*alidayv and survivors' benefits could be provided under either ihe first or the second pillar In a second pillar context judging from the experience tn Laun America, about 2-3 percentage points would have to be diverted to insurance companies to purchase inalidit and pre-renrement survitors' benefits. A decision about ths issue depends on how prepared the insurance market in Croatia. presumably in partnership wih establish European fums. is to take on such underunting

.Annuti Rules. Upon retirement. accumulations from the individual accounts %%ould be in the form of annuities or. altematively. installment payments according to prescribed life tables. For those who are married, annuities would be irre%ocable joint-and-suri%or annuities. Annuities either could be issued by a single insurer (e.g., the Pension Institute backed by. for example, indexed government bonds) andior by competing pri%ate insurance companies using prescribed annuity tables In the latter case. the pensioner would select an insurance company and use the capital accumulated in the individual account to purchase an annuitN. Careful thought needs to be given to the costs and advantages of allowing competing annuity issuers 'ersts a single conmon annuity pool

Centralized vs. Decenraized.dmnistration. In the first phase of the reform, there would be a centralized "cleannghouse" for the indi%idual accounts to minimize the transaction costs which consist in contribution collection, monitorng payment compliance and other administrative tasks. One possibilin is to assign this clearinghouse function to a distinct component of the eXisting Pension Institute. Though this component would use the collection and data resources of the Pension Institute, it would be seen more as an agent of authorized second pillar funds. It also could serve as the designated custodian' depositor\ to monitor the investment beha%ior of the pension mutual funds. At some later date, it could be decided to move to more decentralized administration of the individual accounts

This clearinghouse function should not be confused with go%ernmental superision and regulations go%erning the second pillar pension funds and,or other financial intermediaries. These responsibilities could be lodged in the Finance Nlinistry. the Securitie; and Exchange Commission, or in an independent authority such as exi.;ts in Australia that regulates both insurance and pensions. Coordination with insurance regulation, especially in the field of annuities, is particularly cntical

6.44 Sell-OffApproach. Under this second approach, the government would sell off the assets now held by the Pension Institute or designated for pension reform. This sell-off should take place over a several year period so as not to depress market prices. Provided there is a separate accounting of these assets, there need not be an exact match between the PAYG system's financing needs and the sales: if the sales occur relatively quickly, the proceeds could be banked; if they occur more slowly, some bridge financing by the government may be necessary. During this period of the assets being liquidated, it might still be prudent to move the actual management of the assets out from the hands of the Pension Funds, into the hands of several professional asset managers under contract. This would begin to untangle the government from enterprise governance. 85

6.45 Under this approach, several second pillar institutions would have to be designated through a bidding process. Like under the first approach, rules would have to be developed so that asset managers have some of their own capital at risk. Decisions would have to taken about how much risk/reward difference would be allowed the competing managers. Beginning in 1998 to 2000, individuals with one to three years' worth of accumulations in their notional second pillar accounts would convert those accounts into shares of one or more of the authorized second pillar mutual funds. Thereafter, second pillar contributions would go directly to purchase additional shares.

6.46 The principal concern about this approach is whether the market for Croatian companies can absorb a sell-off of these assets in the time period necessary to finance the pay-as-you-go gap, or whether the assets sell at a deep discount because of the lingering uncertainties about Croatia's economy and the information gaps that exist in emerging markets. There are, however, at least three strong advantages that make this approach preferable to the other approach. First and foremost, it enhances the credibility of the second pillar. No matter how transparent the allocation and valuation process under the first approach, it may not be possible to convince workers of the value of second pillar pension funds that begin with a preset portfolio. Of course, many of the assets sold off by the Pension Institute will find themselves bought by the fledgling second pillar pension funds, but it will be the managers of those pension funds who will determine their market price. Second, it will channel at an earlier stage additional liquidity into capital markets, thus speeding up their development. Finally, sales of Pension Fund assets will start to 'unlock' what is now a frozen market. Most of Croatia's equity is still held by the Privatization Fund, the Pension Institute, the banks and, in case of the state-owned enterprises, the State directly. Managers, often with relatively small stakes in their enterprises, are able to exercise control either without any effective oversight by the nominal owners or without having to obtain majority control alone or with partners. If liquidity is to develop soon in Croatia's markets, all the current institutional owners have to act jointly.

In summary, transition to a Jimded second pillar in Croatiawill require four major commitments by its society:

J a willingness of those in their late middle-age to work longer for the same or greater lifetime consumption (that is, to accept an increase in retirement ages over the next ten years);

G a willingness of the younger population to accept lower replacement rates in the 2003-2020 periodin the reformedpublic (pay-as-you-go) system in order to accumulatenew savings infimded secondpillar accounts;

J a willingness among policy-makers, enterprises and individuals to increase contribution compliance, both to help finance second pillar accounts and possibly to slightly lower the total contributionrate; and

U a plan to finance losses in public accounts resultingfrom the introduction of the second pillar, includingthe use ofprivatization revenues to cover these losses. r

a CHAPTER SEVEN

HOW TO REFORM THE TAX SYSTEM?

SECTION 1 - RECENT DEVELOPMENTS AND REVENUE PERFORMANCE

7.1 Croatia has enjoyed the mixed blessing of a particularly buoyant tax system (Graph 7.1). Graph 7.1: Government Expenditure and During the early years of transition (1991-93), Revenue Government revenues did decline somewhat -- 55.0% from 33 to 30 percent of GDP -- but not in the proportions that led to fiscal crises in other so.0% transition countries, and not enough to prevent the a return to fiscal balance in 1993. A key factor s behind this better performance was that Croatia's tax system, unlike that of many command 0 economies, never relied on the confiscation of State enterprise surpluses, which collapsed .o0% elsewhere after the transition. The tax system's performance turned even more impressive during 3 1994-96: Government revenues increased from 30 to 46 percent of GDP, helping Croatia maintain a 2 991 1992 1993 1994 1995 1996 1997 broad fiscal balance in spite of rapidly escalating expenditure. Overall, there is little doubt that e revenue performance contributed in a major way to the stabilization effort.

7.2 The downside is all too clear. As mentioned, Croatia is now one of the highest-taxed economies in Central Europe. But there is more. The crucial need to boost fiscal revenue, and insufficient progress towards a modern tax administration, have delayed the full overhaul of the tax system. In other words, the contribution of fiscal management to macroeconomic stability was paid for by a higher level of distortions, and inefficiency, at the microeconomic level. A clear example of this tradeoff was the postponement of the 106 introduction of the value added tax (VAT) , for fear of an untimely loss of revenue. Along the way, Croatia appears to have lost, tax-wise, the relative advantage that it once enjoyed over other transition countries. If it is to maintain its international competitiveness, and embark on a sustained growth path, it now needs to deepen and complete the reform of the tax system.

7.3 The key development in Croatia's tax system, since independence, was a marked shift towards indirect taxation, which was heavily relied on to finance the additional expenditure requirements (Table 7.1). During 1991-96, indirect taxes increased from 9 to 23 percent of GDP. Their share in Government revenues increased from 28 to 50 percent, (from 60 to 80 percent for the Central Government alone). These developments contributed very much to aggravating the level of tax-induced distortions in Croatia, as the lion's share of indirect tax revenues is derived from a sales tax that was only partially reformed in 1994. The weight of the sales tax relative to GDP, 14 percent, is also one of the highest in the world and by far the

106 The introduction of the VAT, legislated in 1995, was initially postponed until the beginning of 1997. In November 1996, the authorities decided to delay the reform until further notice, and is now scheduled to become effective in January 1, 1998. 88

highest in Central Europe (Table 7.2). Other indirect tax revenues account for 8-9 percent of GDP, derived, in broadly equal shares, from customs duties and excise taxes.

7.4 Despite a laudable rationalization effort, the 1994 reform did not go far enough, and left the sales tax saddled with cascading effects, and four rates ranging from 32 percent (general) to 15.5 percent. Prior to 1994, the sales tax covered many production inputs and had therefore serious cascading effects. In addition, it featured eight different schedules/rates, with the top rate as high as 50 percent for final consumption goods. Although the 1994 reform endeavored to restrict the sales tax to final consumption goods, a number of those also serve as production inputs (fuels, electricity, computers, transportation and other services), resulting in at least some degree of cascading. The 1994 reform did not go far enough either in terms of simplifying the rate structure. It maintained four rates (the general rate of 20 percent, 15, 10, and 5 percent), to which apply a 10 percent surcharge (i.e., the general rate becomes 32 percent: 1.2*1.1=1.32). In March, 1996, the standard rate of was further reduced from 20 to 15 percent, leaving the sales tax ranging from 26.5 percent (=1.15*1.1) to 15.5.

Table 7.1: Central Government's Tax Revenues

in percent of total

Tota tax reve nues I100.0% 100.0% 100.0% 100,0% 100.0% 100.0% 1 00.0O%

Direc taxe 71.7% 49.1% 45W8 47.5% 47.7%S 49.1% 47.f% Payroll contributions 53.5% 38.5% 37.6% 36.3% 36.5% 36.8% 37.4% Personal income tax 15.2% 8.6% 5.7% 9.2% 8.4% 9.2% 6.8% Corporate income tax 3.0% 1.7% 1.7% 1.7% 2.4% 2.8% 3.1% Other 0.0% 0.3% 0.5% 0.3% 0.3% 0.4% 0.4%

Indirettaxes 2k.3%4 09% 54.5% 55 2.% 50.9% -52.4% Indirect taxes domestic 24.6% 38.7% 44.8% 42.6% 42.8% 42.1% 43.5% Indirect taxes trade 3.7% 12.2% 9.7% 9.9% 9.5% 8.7% 8.9% In percent of GDP

Total tax revenues 33.1% 31.1% 30I2 41.1% 43.9 W14%432 Direct tas 23.8% 15l3 13.7%-95 09 17 06 Payroll contributions 17.7% 12.0% 11.3% 14.9% 16.0% 16.2% 16.2% Personal income tax 5.0% 2.7% 1.7% 3.8% 3.7% 4.0% 2.9% Corporate income tax 1.0% 0.5% 0.5% 0.7% 1.1% 1.2% 1.3% Other 0.0% 0.1% 0.1% 0.1% 0.1% 0.2% 0.2%

Indirecttaxesdomestic 8.1% 12.0% 13.5% 17.5% 18.8% 18.6% 18.8% Indirect taxes trade 1.2% 3.8% 2.9% 4.1% 4.2% 3.8% 3.8%

memo: local Government 3.6% 2.5% 2.4% 2.9% 2.8% 3.0% n.a Source: Ministry of Finance

7.5 Another important feature of Croatia's tax system is its heavy reliance on payroll taxes. Like many transition countries, Croatia used to finance generous social expenditures through payroll contributions, which were the largest source of Government revenues in 1991 (54 percent). Payroll contributions did recede relative to tax revenues (37 percent in 1996), because indirect taxation increased, but not as a percentage of GDP: payroll contributions still account for 16 percent of GDP, hardly less than in 1991. This level places Croatia at the higher end of transition countries (Table 7.2), and far ahead of OECD countries. Payroll tax levels that are out of line with competitor countries will affect Croatia's international competitiveness, since they bear directly on labor costs, unlike the sales taxes or the future VAT which are zero-rated for exports. In addition, high payroll taxes tend to discourage formal hiring, and push economic activity underground. 89

7.6 The major tax reform of the past five years was the introduction of a new personal income tax (PIT), and corporate income tax (CIT) in 1994, replacing what was a very complex and inequitable systemlo7 Both taxes present the key features expected from modem taxes, i.e., a broad base, uniform and relatively low rates, and the quasi-elimination of exemptions (see Box 7.1). In addition, the new income tax system presents original features that aim at ensuring neutrality between consumption and savings decisions of individual taxpayersl 08, and the enterprises' choices of equity vs. debt financingl09

7.7 Despite these positive aspects, the new PIT-CIT system did relatively little to reduce tax-induced distortions, because of its disappointing contribution to Government revenues. Altogether, the two taxes have been yielding 5 percent of GDP since their introduction -- much less than the levels observed in developed or even post-transition economies. The apparent improvement over the old taxes' revenue performance in 1993 (by 2 percent of GDP) was not so much due to the design of the new taxes, as to the recovery of real wages. This explains why the PIT fared relatively better, yielding 4 percent of GDP, although this level is lower than in countries at similar wage and GDP levels, such as Poland, Hungary or Slovenia. On the other hand, the performance of the CIT, only 1 percent of GDP, has been particularly weak, although broadly consistent with the reported results of profit-making enterprises (about 4 percent of GDP). Table 7.2: Structure of the Tax System in Selected CEE Countries (1995)

in %/of GDP Corporate Tax Personal Income Payroll VAT or Sales Trad:e tas Tax Contnibut6ons Tax Albania 1.6 0.3 4.5 2.7 3 Bulgaria 6.7 4.3 10.4 9.5 2.7 Czech Republic 5 5.7 18.5 8.1 1.5 Hungary 1.1 6.8 11.8 7.5 4.4 Poland 3.1 9.7 11.1 12.9 5.7 Romania 4.4 0 8.3 5.5 1.5 Slovak Republic 6.6 4.7 11.4 11.5 2.1 Slovenia 0.6 6.9 19.1 13.5 3.7

Croatla 111 3:7 1188 4.2 average 3.4 4.7 12.3 10.0 3.2 Source: World Bank

107 The corporate tax featured a host of exemptions and/or reduced rates in favor of, for instance: public enterprises; enterprises employing disabled persons; establishment of activities on the islands. Personal income taxation was schedular and entailed many exemptions and different rates. 108 The personal income tax is one of the few, if not the only, consumption-based taxes world-wide. It exempts all interest and dividend income, as well as most capital gains. This feature, which ensures neutrality between present and future consumption decisions, is rather positive in Croatia's present context of low savings rates. Even though the elasticity of overall savings to after-tax return rates has been questioned, it may help stimulate financial savings and financial markets. 109 Neutrality between equity and debt finance is sought through two features of the income taxation system: (i) the exemption of dividends under the PIT is a clearcut response to the well-known issue of the double taxation of corporate profits; and (ii) the CIT base (net changes in equity) is corrected to allow for an opportunity cost of capital (5 percent p.a., after inflation). 90

SECTION 2 - DIRECTIONS FOR TAX REFORM

7.8 The implementation of the expenditure reform measures discussed in Chapter V and VI would enable Croatia to reduce the tax burden by 8-10 percent of GDP aver the next 4-5 years, thus leaving room for higher domestic savings. How this reduction should be achieved, however, is equally important. Tax cuts should be used as the opportunity to eliminate the distortionary features of the tax system, and align Croatia's tax structure with that of its main competitors. From this perspective, they should be allocated, broadly in equal shares, to two policy objectives: first, absorb the revenue loss that is likely to result from the introduction of the VAT as currently designed, and reduce VAT rates further if possible; second, reduce the taxation of labor, relative to capital. As a third objective, Croatia needs to tackle more efficiently the issue of tax evasion, with a view to broadening the tax base and lowering tax rates at a given level of tax revenues: this should be achieved by strengthening tax administration.

Box 7.1: Croatia's Tax System Personal Income Tax (PIT). Introduced on January I. 1994, replaced a scheduler system which left several sources of retenues untaxed, and displayed no clear progress. The PIT is one of the rare examples of a consumption-based tax world- laide. if not the only one The consumption treatment is achieved by exempting from the base all interest and dividend income, as w%ell as most capita] gains (also a%oiding double imposition of dividends). Income is broadly-defined, and includes presumpike assessment of agricultural income. There is a general deduction of 60 percent of the minimum salary (itself about 40 percent of the a%erage wage), increased by Il( percent for a dependent spouse, another 10 for the first child, 20 for the second, and 10 for each additional child. Income is then taxed at 20 percent idown from 25 percent during 1994-96) until three times the minimum annual salary and. beyond. at 35 percent. The PIT is withheld monthly by employers after allowing for deductions. All taxpayers with incomes other than wages must file a return at the end of the year. Corporate Income Tat (CIT). Effective Januarn 1. 1994. Co%ers all'entrepreneurs', including individual businesses beyond certain thresholds Flat 35 percent rate (up from 25 percent during 1994-96) As the only rax incentive. the Government may reduce the rate for the reconstruction and development of certain areas. The base is not the conventional revenue minus allow&ed expenses. but changes in equity, adjusted for mrflation and a 5% opporunity cost of capital (in an attempt to address the distortions caused by inflation and the uneven treatment of debt %s. equit- finance). The tax base is increased by the amount of 'e%cess' interest. depreciation or other pay ments, and decreased b the amount of dividends received. capital increases and other items. Advance payments are due based on the pre% ious yeat's tax. Social Security Taxes Pay able on gross wNages by employers and employees, as follows. health insurance (7 percent each): pension insurance (1275 percent each); child fund 12.2 percent by empliyees); and unemployment (1.9 percent by employees). Pay roll taxes are earmarked to three extrabudgetary funds (pensions, health and unemployment). Sales Tax. Reformed in July 1994, from a system confising sales and excise ta.ation, and featuring 18 rates. some as high as 140 percent. The sales tax applies to the sale of goods and sen ices intended ;or final consumption (although a number of them are also used as production inputs). The current four rates. after the latest --March, 1996- modification are: general (15 percent): construction materials (10 percent): food. health and others (5 percent). In addition there is a surcharge of 10 percent on all rates, bringing for example the general rate to 26.5 percent (1. 15F1.10). The New VAT. Estabbshed by law in 1995. and scheduled by the Government to come into force on January 1, 1998 Wide coverage, with only rents, financial services, health services and educational services exempted. Single rate (22 percent), with exports zero-rated. Excise Taxes. Specific taxes levied on 'tice' goods (alcoholic beverages and tobacco). oil products, new passenger cars and non-alcoholic bet erages. Customs Duties. No taxes on exports. The tariff code ranges between zero and IS percent, and there are quotas and specific duties There is a 10 percent surcharge. The effective a%erage rate is about 10 percent Property Ta%es There is a 5 percent tax on the transfer of immovable properties. but not tax on property ownership.

Introducing the VAT

7.9 Given the shortcomings and the considerable weight of the current sales tax, the introduction of the VAT is an indispensable building block of a full-fledged reform of Croatia's tax system. The proposed VAT is, indeed, a well-structured tax, with limited exemptions, a single rate (22 percent), and a conventional 91 crediting system. Regrettable as it was, the postponement of the reform gives the tax authorities an opportunity to maximize chances for a smooth transition. While the revenue impact of the VAT is typically the main issue faced by reforming countries, the Croatian tax authorities should also turn their attention to the distributional effects of the new VAT.

7.10 Two factors could cause the VAT to result in a revenue shortfall. The first one, the elimination of the sales tax's cascading effects, is difficult to assess accurately 10: it should be monitored closely in the early months of implementation and, should the need arise, be corrected by tax policy measures, namely, increases in the rate of the value added, or other, taxes. The second risk, poor implementation and compliance" 1 , can and should be minimized through thorough preparation. A sample of the preparation activities to be carried out by the tax administration include: establishing the taxpayer registration and control systems; developing the crediting system; cooperation agreements for collections with the Customs administration, the Payments Institute and banks; issuing VAT instructions, and implementing taxpayer education programs; and restructuring the Tax Administration, training new personnel and procuring of new equipment. While many of these tasks are well underway, at least some of them would not have been completed in time for the introduction of the VAT on January 1, 1997, and should be finalized as a matter of priority: for instance, instructions to taxpayers, procurement of equipment, and the reassignment of staff within the Tax Administration.

7.11 The second issue lies in the distributional impact of the taxation of goods -- particularly foodstuff -- which are currently exempt from the sales tax. This issue is evidently compounded by Croatia's choice of a single rate structure, and by the high tax rate which is called for if revenue neutrality is to have any chance to be achieved. As a result, the VAT might have serious adverse effects on the poorer households. Yet, the principle of one single rate, no exemptions, makes the VAT a tax particularly 'clean', and easier to administer, and should be adhered to. The Government's preferred approach, alleviating the burden on the poorest through means-tested assistance, is in principle the right one. Implementing this approach in the absence of any serious survey of households budgets and expenditures, however, will be a non-trivial exercise. In order to optimize the use of the budgetary resources that would support the poorest households, the preparation work needs to be stepped up, and focus, in particular, on determining more specifically the following parameters: the minimum subsistence level in Croatia; the number of households whose income does not reach this level; the exact impact of higher foodstuff prices on poorest households, taking into account the current composition of budgets, and possible substitution effects; and how to best target assistance to those who need it.

Reducing Labor Taxation

7.12 Croatia's tax system combines several features which may excessively penalize the use of labor, as opposed to capital, inputs in production functions. On the one hand, capital inputs largely escape taxation, because of the limited revenues yielded by the corporate income tax, and the absence of any taxation on the stock of capital in Croatial 12. Labor income, on the other hand, bears a heavy tax burden, the addition of

110 Different estimates have been produced, ranging anywhere between zero and 5 percent of GDP. The most recent assessments, however, suggest that revenue shortfall on this account could be in the order of 2-3 percent of GDP.

The crediting system, in particular, is untested in Croatia: it could open the door to large-scale fraud, as experienced by other reforming countries, rather than improve immediately compliance, an outcome which is achievable when the VAT is enforced by mature tax administrations. 112 There is a 5 percent tax on the transfer of immovable property. 92

payroll contributions and the personal income tax. Altogether, these two taxes drive a wedge of about 80 percent between take-home pay and the employers' gross wage costs (Table 7.3), a level which is out of line with international standards, particularly in OECD countries. That some Central European countries (Hungary, Czech Republic, Poland) emulate these levels of labor income taxation has little redeeming value. Particularly in the recent context of real wage increases, and lower labor force participation, high labor taxation is likely to perpetuate unemployment, encourage the infornalization of the economy, and adversely affect Croatia's international competitiveness. Achieving greater neutrality in the tax treatment of labor versus capital inputs should therefore be one of the main goals of tax policy in the coming years, and will require a two-pronged strategy.

Table 7.3: The Wedge between Labor Costs and Take-home Pay

Employer pays 119,42 122 12 122 82 122.82 121 57 o/w health insurance 7.20 9.30 10.00 7.50 7.00 o1w pension insurance 10.40 11.00 11.00 13.50 12.75 olw water, rent, chamber of commerce 1.82 1.82 1.82 1.82 1.82

Worke r gross wage 100.00 10 00 10 00 1 000 1 00 d.00 olw health insurance 7.20 9.30 10.00 7.50 700 olw pension insurance 10.40 11.00 11.00 13.50 12.75 olw child allowance contribution 2.20 2.20 2.20 2.20 2.20 olw unemployment insurance 1.90 1.90 1.90 1.90 1.90 olw personal income tax 13.43 9.76 6.70 14.52 12.23

Worker net wage 87,78 18.1n 6 88m 84, 02T 66,84

We dge net wage as a percent of employer's costs 56.8% 55.9% 56.9% 52.1% 55.0% employers' costs as a percent of net wage 176.2% 179.0% 175.8% 191.8% 181.9% Source: Ministry of Finance, and Wortd Bank estimates

BringingCapital in the Tax Net

7.13 The effective level of corporate taxation should be brought in line with international standards. Corporate tax typically yields 3-5 percent of GDP in developed economies, and even more in Central European economies. In the medium-term, Croatia's 'anomaly' should be corrected by better tax enforcement, and the restructuring or exit of inefficient enterprises. In the short-term, some positive results can be expected from the recent increase of the corporate tax rate, from 25 to 35 percenti1 . Croatia could also give serious consideration to two other measures: (i) introduce a presumptive taxation for small- and medium-sized businesses, which are notoriously more difficult to bring into the tax net; this measure could be imposed on a temporary basis, and phased out as tax administration reaches out to the private and informal sectors; and (ii) establish a minimum tax on capital (fixed assets, or equity); this minimum tax

113 The increase from 3 to 5 percent of the opportunity cost of capital allowed by the Tax Law --effective since January 1, 1997-- (Box 7.1) might offset the effect of the higher corporate tax rate. 93 could be used as a credit towards the corporate tax, in order to avoid overburdening those enterprises that are already paying it.

Shifting Payroll Taxes to General Taxation

7.14 Payroll taxes should be reduced Table 7.4: Two Options to Reduce the Level of Payroll Taxes to more reasonable levels, from the current 45 percent to around 30 percent. Payrl tax At present Option A* Option B* As discussed above, achieving this objective through a reduction of the Water, rent and Chamber of commerce 1.82 0.00 0.00 helh ad pninEmployment Fund 1.9 0.98 0.98 underlying udrynhealth and pension 0.00 0.00 expenditure would be at best lengthy. A ChIrne 2.2 Helhisrne19.5 17.8 12 much more effective option would Pensrne consist in transferring to the general budget part of the expenditure financed through payroll taxes. Natural thrugh payolltaxs. atualTotal (percent of payroll) 45.4 38.1 30.3 candidates for such a transfer would be o 12.1 those expenditure items currently borne Total (percent of GDP) 18.2 14.4 by the extrabudgetary funds, but which fulfill redistributional, rather than Difference (percent of P) -3.3 -1.1 insurance, objectives (see Box 7.2). As illustrated in Table 7.4, payroll taxes * See Box 7.2 for adescription of options Aand B. could be reduced from 45.4 percent to Source: World Bank anywhere between 30 and 36 percent, depending on the options

7.15 As a result of such a transfer, central budget expenditure would increase by 4-6 percent of GDP, depending on the options chosen. While about 1 percent of GDP could in principle be recouped through the CIT (assuming that employers' contributions, rather than workers', have been reduced), it would be undesirable to finance the 'revenue loss' by higher tax rates: the PIT has virtually the same tax base as payroll taxes, and sales tax rates are already very high. This implies that the 'new' centrpl budget expenditure items should be financed through the reduction of expenditure discussed in Chapter VI, and implemented as it takes hold, over a 2-3 year period.

Other Tax Measures

7.16 Introducinga 'cash-flow' tax at the corporate level The CIT displays a fair degree of complexity, and is not fully consistent with the consumption approach elected by the personal income tax. The natural complement to the consumption-based personal tax would be, at the corporate level, a cash-flow tax, where the tax base is given by the difference between revenues and expenditure on wages, materials and the full cost of capitalpurchases. No deductions for depreciation or interest are allowed since the full expensing for capital is equivalent to deducting the economic cost of depreciation and the financing costs from the tax base (whether this is imputed cost of equity finance or debt financing costs).

7.17 The efficiency advantage of this approach is that it eliminates any possible distortions caused by inflation in the measurement of income (all computations are preformed at current money values), avoids any bias towards debt financing, and that it may be more conducive to savings and investment (because with a cash-flow tax the marginal effective rate of taxation on investment is zero). By contrast, the current profit tax keeps depreciation and interest deductions, and introduces a special deduction for the opportunity cost of 94

capital adjusted for inflation. This is a more complex system which is unlikely to eliminate the distortions of profit taxation entirely.

Box 7.2: Options To Reduce Pa)roll Taxes

Two options could be considered to reduce pay roll taxes: (i) transfer to general taxation expendirures clearly pursuing redistributional, rather than insurance. objecti%es (option A), (i) also finance from general taxation expenditures which could be financed through an insurance prncple, but for w%hich the linkage is more indirect and difficult to calculate. The Health Insurance Fund Option A. Several items financed by the Health Fund are redistributic.nal in nature: (i) maternay leave benefits beyond 3 months after birth, a pro-natalist. rather than medical, measure: (ii) health care for refugees; and (iii) health care for non-insured workers. These items total 8.8% of the Health Fund's expenditure Shifting their financing to the general budget would permit a reduction in payroll taxes from 19 50-o to about 17.8%. of gross wages Option B. In addition, it would be possible to transfer to general taxation the costs of health care for elderly people and reduce payroll taxes by another 5.8 percent. These expenses could be viewed as insurable, particularly if ones adopts a long-term perspectie of health insurance (today's health contribuuions also serve to finance post-retirement health care needs). On the other hand, actuarial fairness is difficult wThen it comes to old age health insurance, and the issue of who should bear the burden has given raise to unnecessary arguments, and shift of responsibility, between the Headth and the Pension Fund. These expenses could as well be transferred to the budget, serving by the same token the purpose of reducing payroll taxation The Pension Fund Option A only. About 13 percent of the Pension Fund's expenditure relates to a 'ariety of'merit pensions', served irrespective of the actual contribution record (185.00) individuals. including World War If veicrans and ex-political prisoners). There is little doubt that the subsidy element should be financed out of general taxation. The transfer would allow a reduction of about 2.7 percentage points in payroll taxes. The Employment Fund Option A. The Employment Fund pays for the pension, health and vhild benefit contributions of those unemployed including a majority of persons no longer eligible for unemployment benefits. Transferring these expenses to the general budget could reduce payroll taxes by .3 percent of payroll. Option B. rransferring to general taxation the Employment Fund's e%penditure on acuve labor measures, and surplus. would yield another reduction of .65 percent of pay roll. The Children's Fund Option A only. The means-tested child benefits are a perfect example of what should not be financed by an earmarked payroll tax. Although the allowance is not related to earnings, it is financed by a 2.2*'o payroll tax This is a redistributive benefit which should be financed by general taxation, if the policy objectine is to support families for having children. Three Minor Earmarked Taxes. Option A only. Three small leties account for a total of 1.82 percent of earmarked payroll taxes. The largest is a tax of 0.76% of payroll which pay s for 30% of expenditures on water and sewers (the balance being paid for b% means of metered consumption). A rent subsidy is also financed by a 0.7% tax on payrolls. Finally. the Croatian Chamber of Commerce is partly financed by a 0.36% tax on pay roll. None of these taxes has an% benefit ratior ale whatsoever and all of these redistnbutuonal measures should be subsidized, if at all, by general taxation.

7.18 Excise taxes. The Government should consider limiting the scope of excise taxes to products with negative social externalities (tobacco, alcohol and petroleum products). There is no justification in the current overtaxing of goods such as new passenger cars, or non-alcoholic beverages. In addition, the rate of excise taxes should be 'ad valorem' rather than specific.

7.19 Property tar. The current tax on transfers of real estate (5 percent) is inferior in revenue potential, and has more perverse economic effects, than a conventional tax on the ownership of real estate. In particular the tax on transfers will be an impediment to the development of active real estate markets and will tend to drive transactions underground. The Government should explore the option of replacing it with a property tax with clear and simple valuation rules and a uniform rate. 95

Strengthening Tax Administration

7.20 The major challenge facing the Croatian fiscal system is to develop a strong tax administration. This is a problem common to all economies in transition to a market economy The dismantling of the tight control systems of the socialist state, and the privatization of the economy, require an entirely new paradigm for tax enforcement in Croatia: a combination of self-declared compliance, expanded collection systems, and efficient ex-post auditing. There is anecdotal evidence that the level of tax evasion is already high in Croatia, as much as 30 or 40 percent of collections by official estimates, but probably higher. The lack of an adequate level of tax enforcement will result not only in lower than expected revenues but also in a distorted distribution of tax burdens, and incentives for further tax evasion.

7.21 Croatia made a good start in terms of establishing its tax administration. The most important reform was the creation, in 1993, of a central Tax Administration Service and a 'Financial Police' (see Box 7.3), within the Ministry of Finance. These agencies were created by pulling resources from the former Yugoslavia's Social Accounting Service (SDK)114 and from local tax offices, previously in charge of tax enforcement for incorporated enterprises and for individual taxpayers, respectively. Croatia's Tax Administration Service in some areas is off to a better start than other tax administrations in Eastern Europe. For instance, it inherited from SDK a telecommunications network with a central database of taxpayers for at least all legal entities. All regional offices and most of the 119 branches are now on-line with the central office in Zagreb. In addition, there exist well established taxpayer identification numbers as well as current accounts for each taxpayer.

7.22 The accomplishments of the Tax Administration have been substantial over a short period of time. However, enforcing taxes in a market environment with a tax structure characterized by self-reporting taxes will demand in years to come a sustained effort, and it is important at the present time to avoid self- complacent attitudes. There remains, indeed, major problems with tax administration, including its organization structure; collections; audit and control; personnel and training; and legal issues.

Organization

7.23 The current organization of the tax administrationfinction, as well as that of the Tax Administration unit within the Ministry of Finance, leaves room for rationalization, and efficiency gains. When the centralized system of collection, audit and inspection, carried out by the former SDK, was broken up, collection proper remained with SDK's successor, the Payment Institute (ZAP). The audit and inspection functions were devolved to the Tax Administration unit (central budget taxes) and to the three extrabudgetary funds (payroll taxes). At the same time, the Financial Police was authorized to carry out more in-depth audits and inspections of the larger enterprises, including the payment of payroll taxes. This distribution of responsibilities leads to overlaps, oversights, and misallocation of scarce resources. It should be revisited, to unify the enforcement of payroll contributions, and assign clear and separate responsibilities to the Tax Administration and the Financial Police. In addition, there is scope for improving the internal organization of the Tax Administration proper.

114 In addition to collecting taxes and social security contributions from legal entities, SDK was performing the function of a payment system, and was also responsible for auditing all enterprises. Croatia has undertaken to dismantle the SDK, which was stripped of tax and Government audit functions, and restructured into a Payment Institute (ZAP). 96

7.24 Unify the enforcement of payroll contributions The assignment of enforcement responsibilities for payroll taxes to the three extrabudgetary funds is probably the least efficient solution possible. It implies that the same enterprise can theoretically be audited by five different entities (the three funds, the Tax Administration, and possibly the Financial Police). At the same time, the extrabudgetary funds have uneven, but consistently insufficient, capabilities to carry the task. The staff assigned to enforcement functions in the funds is none for the Employment Fund (which chose to rely on the ZAP, although this agency no longer performs audit activities), 33 for the Health Insurance Institute, and 200 for the Pension Fund. The Health Institute and the Pension Fund operate 20 and 27 tax administration branches, respectively.

7.25 There is a clear case for unifying the enforcement of payroll taxes within a single entity. This entity could be either the Tax Administration itself, which would operate for the extrabudgetary funds on an agency -- and fee -- basis, or a Social Security collection agency, a model used in some Western countries. However, this reform may not be achievable before two years or so, considering on the one hand the current workload of the Tax Administration (implementing the VAT), and on the other hand the time needed to establish and organize an ad hoc agency. In the short-term, there are a number of steps that could be taken by the tax authorities in order to improve the efficiency of the current system. These include: (i) having the extrabudgetary funds audit all payroll taxes in fewer enterprises, rather than a single tax in a larger number of enterprises; (ii) accordingly, coordinate closely the audit programs of the three funds, and rationalize their branch networks; and (iii) harmonize legal definitions and penalties across the different payroll taxes.

7.26 Clarify the responsibilities of the Tax Administration and the FinancialPolice. As discussed, the responsibility of the Tax Administration and the Financial Police overlap in the area of tax enforcement. Although the two units endeavor to harmonize their work plans, this arrangement may lead to duplication of audits, waste of resources, conflicting interpretations of the laws, and other coordination issues. It would be preferable to unify tax enforcement services within the current Tax Administration, which would be clearly in charge of enforcing all aspects of the tax law, including taxpayer control and audit. The other activities of the Financial Police, such as the investigation of fraud by government agencies, including by the Tax Administration, would be more efficiently performed in a transformed Government Audit Office.

Box 7.3: Tax Administration and Financial Police

The Tax Administration is organized into a central office in Zagreb 20 regional offices located in countN seats, and 119 branches of the regional offices. It has a stafT of over 3,000. The Cental Office is organuzed into fi%e departments: standardization of activities; taxpayer control; appeals and legal issues; forecasting and analysis; and organization and general services sector. In part because of the past history of excessive administratie deentralization, the current organization of the Tax Administration emphasizes coordination and control of regional and branch offices by the central office Each branch has tax advisors that coordinate all activities for each particular tax, ensunng that unilbrm procedures are followed in all branches. The work in the regional offices is organized in three sections: collections, control and audit, and general ser% ices. The section on control and audit has a number of inspectors who are responsible for large La.paers in the region and who supervise the activities of inspectors at the branch offices. The Financial Police was created at the same time as the Tax Administration, and is also part of the Ministry of Finance. The mandate of the Financial Police overlaps with the enforcement and audit functions performed by the Tax Administration, but also includes responsibility for internal control and audit of all Government agencies The Financial Police are entitled to make surprise or pre-arranged visits for the purpose of verif) ing the correctness of documents, speciall> tax documents, and the declarations of physical goods with the purpose of controllng smuggling and tax evasion. It is also organized into a central office in Zagreb and regional offices in each county seat. The Financial Police currenil) has a staff of 1100 of which 800 are inspectors. 97

7.27 Complete the internal organization of the Tax Administration The Tax Administration needs to deepen its reorganization along functional lines, by developing dedicated structures exclusively in charge of: taxpayer registration and control programs; collections and reduction of arrears; office and field audits; internal control; and computerization and information systems. Such functional areas do exist in the current structure but are not always focused on these specific tasks. In particular an internal control unit should be charged with the development of 'objective' performance criteria in each of the functional areas of collections, registration, and audit. This could be facilitated by keeping 'performance accounts' for these items on individual inspectors, branches and regional offices. The top cadres of the Tax Administration would benefit from training in modem management techniques. The eventual effectiveness of the Tax Administration will depend crucially on the existence of internal control and audit programs.

Collections

7.28 Although tax arrears (taxpayer accepted liabilities which have not been collected) are estimated to be around 30 percent of collections, the Tax Administration does not appear to have any concrete programs to improve collections. Neither the exact level of arrears nor their nature is known precisely, because current accounts for taxpayers are not systematically updated or consolidated. As a result, the potential use and value of the current accounts for collections from 'stop-filers' and 'late-filers' is considerably reduced. The tax authorities might even be led to discontinue their use to avoid public criticism.

7.29 The Tax Administration should spend more resources on improving and updating taxpayers' current accounts. This information should be used to develop information on the level and composition of arrears, and deliver automatic notification of stop-payers and late payers. The tax Administration should also develop training programs to increase the effectiveness of collection agents, and managerial programs to supervise and increase the effectiveness of these agents.

Audit and Control

7.30 The main weakness of tax administration systems throughout Eastern Europe, and Croatia is no exception, is a defective audit system. Already, in the few years before independence, SDK-performed audits had become thinner and practically ineffective, as a result of understaffing and the disintegration of federal authorities. With the turn toward a market economy, information on economic activity has become scarcer, and taxpayer attitudes toward compliance have hardened. However, the ability of the Tax Administration to audit and enforce tax compliance has not improved in a discernible way. The current level of tax evasion has not been formally estimated but by many accounts it appears to be high and markedly on the increase from pre-independence levels. There is a widespread belief that high tax evasion has negatively affected tax morale, and the compliance of other taxpayers.

7.31 Although the Tax Administration has striven to improve the efficiency of auditing by conducting integral audit programs encompassing the whole spectrum of taxes, it has yet to develop the full range of tools used by modern tax administrations, and address the corresponding training needs. The desirable improvements span four broad areas: (i) concentrate successive audit programs on selected sectors of the economy (this would enable auditors, for instance, to gather the sector-specific information that is necessary to conduct effective audits, such as what constitutes average expense deductions or what is the standard percentage of inputs giving raise to VAT rebates); (ii) develop audit selection programs, using a priori information, in order to maximize detection of frauds, increase collected revenues, and minimize the inconvenience for compliant taxpayers; (iii) make more systematic use of third-party information (e.g., cross-check VAT payments and rebates; or wages deducted under the CIT, vs. reported under the PIT); and 98

(iv) develop internal control programs to assess the effectiveness of the ongoing audit programs, and control the performance of tax inspectors, and entire branches and regional offices.

Personneland Training

7.32 Personnel needs of the Tax Administration are still serious despite significant increases over the past 12 months. Understaffing is, in fact, more qualitative than quantitative. Even though the Tax Administration inherited from personnel that was well-qualified by SDK standards, most tax administration officials lack the skills and experience to enforce a market-oriented and self-assessed tax system. Many of the best qualified, have left to the better-paid private sector.

7.33 Current plans to start a tax administration institute for in-house training are a step in the right direction. The curriculum includes training for two years in a wide list of topics in taxation and administration. It may not, however, be a substitute for very focused programs on audit and collection techniques, and should be combined with short-term, more targeted, training. on specific techniques and programs.

7.34 Tax administration is one of the areas where the competitiveness of public wages has the most seriously eroded, making it difficult to retain qualified staff. Taxation, or information technology, skills are easily transferable, and in high demand by the private sector. Inadequate compensation also affects the morale of inspectors who have to deal with much better paid counterparts in the private sector. This is a problem that has been faced by many other countries in the past, and for which across-the-board solutions are hampered by civil service-wide regulations and pay scales. One solution used in some countries, and which could be explored further in Croatia, has been the outsourcing of services such as computer processinglis. Ultimately, the problem of low salaries and the ability to retain skilled personnel in the Tax Administration can be adequately addressed only through civil service reform, and increased salaries and productivity in the public sector.

Legal issues

7.35 Penalties. Penalties for tax evasion in Croatia are almost invariably fixed, rather than proportional to the level of evasion. A second characteristic is that often the penalties are harsh. It would be more effective to use penalties that are proportional and commensurate to the amount of evaded tax, in order to avoid giving an incentive to large-scale evasion. Also, international practice suggests that commensurate, but effectively imposed, penalties, act as a more effective deterrent against evasion than severe penalties that are unlikely to be imposedi 1116 .

7.36 Taxpayers' rights. Croatia recently enacted an Act on the Rights and Obligations of Taxpayers. Taxpayers can appeal to the local tax office, to the central Tax Administration, and ultimately to the

115 Although the issue of confidentiality and public trust impose particular constraints.

116 For example in the case of the new VAT, closing business operations for one to three years is particularly harsh, and is unlikely to be applied. The experience of other countries has shown that closing businesses for several days can be a powerful enforcement tool when effectively applied. 99 administrative co 17. Beyond this necessary legal framework, however, proper compliance with the tax laws should not be expected unless there are clear and well publicized interpretative findings and opinions by the Tax Administration. In addition, taxpayers should have unimpeded access to expert legal opinions for any questions they may have on interpretation and compliance. This type of taxpayer information services is still weak in Croatia, and should be developed by the Tax Administration.

117 It will be important that both appeals and tax deficiencies for negligence or simply arrears accrue to market interest rates to avoid strategic or gaming behavior by taxpayers. In the case of appeals, interest accrued should be made refundable upon a decision favorable to the taxpayer.

STATISTICAL APPENDIX Table of Contents Paze No Section I Main Economic Indicators Table 1.1 Croatia: Main Economic Indicators (1991-1996) 103

Section II Social Indicators, Population and Employment Table 2.1 Croatia: Population and Demographic Indicators 104 Table 2.2 Croatia: Trends in Employment and Unemployment 105 Table 2.3 Croatia: Employment by Sectors 106 Table 2.4 Croatia: Distribution of unemployed persons according to sex and qualification 107 Table 2.5 Croatia: Distribution of unemployed persons according to age 108

Section III National Accounts Table 3.1 Croatia: GDP by Source at Current Factor Cost Prices (millions of Kuna and 109 percentage of total) Table 3.2 Croatia: GDP by Source at Constant Prices (millions of Kuna - prices of 1994 and 110 growth rates) Table 3.3 Croatia: GDP by Expenditures at Current Market Prices (millions of Kuna) 111 Table 3.4 Croatia: GDP by Expenditures at Current Market Prices (in percentage of total) 112 Table 3.5 Croatia: GDP by Expenditures at Constant Prices (millions of Kuna - prices of 1994) 113 Table 3.6 Croatia: GDP by Expenditures (Growth rates) 113

Section IV Balance of Payment Table 4.1 Croatia: Balance of Payments (US$ Million) 114 Table 4.2 Croatia: Exports by Destination 115 Table 4.3 Croatia: Imports by Origin 116 Table 4.4 Croatia: Exports and Imports according to UCEA 117 Table 4.5 Croatia: Exports and Imports by main commodity group 118

Section V Public Finance Table 5.1 Croatia: Central Government Budget (millions of Kuna) 119 Table 5.2 Croatia: Central Government Budget (percent of GDP) 120 Table 5.3 Croatia: Extrabudgetary Funds (millions of Kuna) 121 Table 5.4 Croatia: Extrabudgetary Funds (percent of GDP) 124 Table 5.5 Croatia: Local Governments (millions of Kuna) 127 Table 5.6 Croatia: Local Governments (percent of Kuna) 127 Table 5.7 Croatia: Consolidated General Government (millions of Kuna and percent of GDP) 128 Table 5.8 Croatia: Estimated Reconstruction Needs (millions of Kuna) 129

Section VI Monetary Statistics Table 6.1 Croatia: Monetary Aggregates 130

103

Table 1.1. Croatia: Main Economic Indicators 1990 1991 1992 1993 1994 1995 1996

Total Population (thousands)" 4,770 4,789 4,782 4,779 4,777 4,776 4775

Rate of Natural Increase (per thousands) 0.7 -0.6 -1.0 -0.5 -0.2 -0.1

(percentage change) Real GDP at factor costs -17.3 -9.0 -3.5 0.5 2.3 4.3

Retail prices (e.o.p.) 136.4 249.5 937.3 1149.7 -3.0 3.7 3.4 Retail prices (Average) 122.6 663.6 1516.6 97.5 2.0 3.5 Manufacturing prices (e.o.p.) 70.9 312.3 1079.1 1075.6 -5.5 1.6 1.5 Manufacturing prices (Average) 146.3 825.9 1510.4 77.7 0.7 1.4

Exports (current US$) 2 ' -18.1 39.7' -15.1 9.1 8.7 -2.6 Imports (current US$) -26.2 16.5' 4.6 12.1 43.6 3.7 (as a percentage of GDP)

Current Account -4.8 8.3 0.9 0.7 -9.5 -7.6 Current Account excluding interest due -2.5 10.5 2.9 2.3 -8.1 -6.3 Consumption expenditures 91.8 80.5 86.7 88.0 98.3 96.7 Gross Domestic Investment 11.3 13.8 14.4 13.6 14.1 14.8 Government 0.8 1.7 1.6 3.6 4.2 6.0 Private 10.5 12.1 12.8 10.1 9.9 8.8

Consolidated General Government Total Revenues 34.1 33.2 31.8 43.2 45.8 46.9 Total Expenditures 39.0 37.2 32.6 41.8 46.7 47.3 Balance -5.2 -4.0 -0.8 1.5 -0.9 -0.5

Total gross reserves (in months' imports G&S) 0 0.1 0.8 1.7 2.2 2.6 Real Money balances (percentage change) Currency in circulation -30.9 -16.9 100.3 21.7 12.9 Monetary Base -41.5 -12.6 115.9 37.6 13.7 MI -42.3 -21.1 118.9 19.2 23.6 Domestic Money (M2) -34.3 -28.3 90.6 16.8 37.5 Foreign Currency Deposits -37.2 37.6 67.1 54.9 49.5 Broad Money -35.4 -4.6 77.9 36.1 44.5 Note: 1/ Population estimates based on the Jure principle. 2/ Starting in 1992, data include trade with former Yugoslavia. Table 2.1. Croatia: Population and Demographic Indicators 1i

1961 1971 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Total Population (thousands) " 4169 4430 4606 4621 4636 4646 4657 4667 4674 4681 4685 4770 4789 4782 4779 4777 4776 4776 Total Population (thousands) 4514 4470 4641 4649 4669 4494

Percent Distribution Male 47.7 48.3 48.4 48.4 48.405 48.4 48.4 48.4 48.4 48.4 48.5 48.5 48.5 48.4 48.4 48.4 48.4 48.4 Female 52.3 51.7 51.6 51.6 51.595 51.6 51.6 51.6 51.6 51.6 51.5 51.5 51.5 51.6 51.6 51.6 51.6 51.6

Urban 41 50.8 54.3 Rural 59 49.2 45.7

Under 15 Years of Age 27.2 22.6 21.1 21.0 20.9 20.9 20.9 20.8 20.4 20.3 20.1 19.9 19.6 19.6 19.6 19.6 19.6 19.6 15-64 Years of Age 65.3 67.2 67.4 68.0 68.4 68.6 68.5 68.4 68.5 68.5 68.5 68.5 68.5 68.5 68.5 68.5 68.5 68.5 Over 65 Years of Age 7.5 10.2 11.5 11.1 10.7 10.5 10.7 10.9 11.2 11.2 11.4 11.6 11.9 11.9 11.9 11.9 11.9 11.9

Live Births (thousands) 74.2 64.9 67.5 66.7 65.6 64.9 62.7 60.2 59.2 58.5 55.7 55.4 51.8 47.0 48.5 48.6 50.2 53.8 2 Crude Birth rate (per thousands) ' 17.8 14.6 14.6 14.4 14.1 14.0 13.5 12.9 12.7 12.5 11.9 11.6 10.8 9.8 10.2 10.2 10.5 11.3

Deaths (thousands) 37.8 44.9 51.4 50.8 55.1 54.2 52.1 51.7 53.1 52.7 52.6 52.2 54.8 51.8 50.8 49.5 50.5 50.6 Crude Death rate (per thousands)' 9.1 10.1 11.2 11.0 11.9 11.7 11.2 11.1 11.4 11.3 11.2 10.9 11.4 10.8 10.6 10.4 10.6 10.6

Natural Increase (thousands) 36.4 20.0 16.0 16.0 10.5 10.7 10.6 8.5 6.1 5.8 3.1 3.2 -3.0 -4.8 -2.3 -0.9 -0.4 3.2 Rate of Natural Increase (per thousands) 4/ 8.7 4.5 3.5 3.5 2.3 2.3 2.3 1.8 1.3 1.2 0.7 0.7 -0.6 -1.0 -0.5 -0.2 -0.1 0.7

Infant Mortality (per l000 live birth) 18.9 18.3 18.7 16.8 16.6 15.9 14.0 13.1 11.7 10.7 11.1 11.6 9.9 10.2 8.9 8.0 Illiteracy (% of pop. age 10 and older) 12.9 9.0 5.6 3.0 3 Gross primary enrollment ' 90.9 87.9 88.5 88.4 88.1 88.0 88.0 87.4 86.1 84.5 83.6 68.7 73.5 74.4 72.7

Source: Central Bureau of Statistics of Croatia and World Bank. Notes: 1/ Population number not corrected for refugees. 2/ Population number corrected for refugees from 1991-1996. 3/ The school season ended in the correspondent year. 4/ Based on population figures not corrected for refugees. Table 2.2. Croatia: Trends in Employment and Unemployment 1/ end of the period 1990 1991 1992 1993 1994 1995 1996 Q2 1997 Q1

Majority state-owned ent. & pub. sector 21 1,670,096 1,482,740 1,221,333 1,054,357 870,787 799,665 Private Sector 31 285,766 343,650 435,200 586,823 716,791 738,804 Total employment 1,955,862 1,826,390 1,656,533 1,641,180 1,587,578 1,538,469 1,469,305 1,450,533

Unemployed (registered) 195,466 283,308 261,050 243,096 247,555 249,070 252,524 284,611 Labor force 2,151,328 2,109,698 1,917,583 1,884,276 1,835,133 1,787,539 1,721,829 1,735,144 Unemployment rate 9.1 13.4 13.6 12.9 13.5 13.9 14.7 16.4 Vacancies 10,701 6,922 8,863 8,426 9,069 7,765 10,669

Source: State Institute for Macroeconomic Analysis and Forecasting (SIMAF)

Employees 1,670,096 1,542,859 1,420,181 1,406,763 1,350,271 1,311,239 1,251,243 1,244,081 Small Owners 68,744 68,535 66,000 66,726 73,461 77,749 78,863 81,025 Individual Farmers 217,022 214,996 170,352 167,691 163,846 149,481 139,199 125,427 t Total employment 1,955,862 1,826,390 1,656,533 1,641,180 1,587,578 1,538,469 1,469,305 1,450,533 Source: Republic Pension and Disability Fund 11 Total employment estimates are based on employees paying pension contributions. 21 Comprises formerly socially-owned enterprise sector as well as government sector. 31 Private sector employment includes: individual farmers, entrepreneurs and their employees, independent professional workers and employees at private enterprises. From 1992 onwards, private enterprises established in the process of privatization are included. Table 2.3. Croatia: Employment by Sectors u(thousands) 1985 1989 1990 1991 1992 1993 1994 1995 1996

Total 1,551 1,618 1,568 1,432 1,261 1,238 1,211 1,195 1,195

Goods and services sector 1,260 1,298 1,243 1,053 904 872 827 792 782.5 -Mining and Industry 542 567 561 462 398 385 368 349 315.1 Extraction of crude petroleum & natural gases 2.4 2.3 2.3 2.2 2.2 2.9 2.8 Petroleum products industry . 6.4 7.3 5.4 5.1 5.0 5.0 5.9 Iron and steel industry 10.7 10.2 7.8 7.3 6.5 5.6 4.3 Manufacture of metal products 51.3 36.8 28.9 28.2 26.4 24.3 20.0 Machine industry 36.6 25.3 21.7 19.7 17.7 15.7 14.3 Manufacture of transport equipment (except shipbuilding) 15.4 13.2 11.5 9'7 9.0 8.6 8.3 Shipbuilding 21.9 21.7 16.4 16.3 15.5 14.1 13.3 Manufacture of electrical equipment 36.2 28.3 24.9 23.9 21.5 20.5 20.2 Basic chemical industry 15.8 12.7 13.4 11.5 11.4 10.7 9.6 Chemical products industry 25.1 21.1 18.6 19.3 18.2 17.7 17.2 Building materials industry 17.2 15.6 13.5 13.2 12.3 11.6 11.0 Timber industry 12.1 8.5 8.8 9.3 9.0 8.1 6.9 Finished wood products industry 35.1 27.5 22.9 22.3 21.2 19.5 19.0 Textile fibre and fabric industry 27.8 20.5 16.2 15.5 14.3 13.2 11.2 Finished textile products industry 60.7 52.9 46.2 48.9 48.3 45.6 39.4 Leather footwear and accessories manufacturing 34.8 24.3 21.4 22.2 23.2 21.2 15.9 Food products industry 54.6 51.1 46.5 44.1 44.2 43.9 39.0 -Agriculture and fisheries 52 54 54.1 48.3 43.2 42.3 39.5 35.2 31.3 -Forestry 16 16 15.1 13.4 11.5 10.8 10.9 10.9 9.8 -Water management 7 6 6.1 5.6 5.0 4.3 4.0 4.0 3.9 -Construction 136 128 118.7 98.8 76,2 66.3 59.0 59.0 61.5 -Transport and communications 124 128 124.9 110.2 95.6 90.0 84.9 84.1 81.8 -Trade 157 166 159.8 142.3 123.9 125.2 116.5 109.8 124.9 -Hotels, restaurants and tourism 80 86 78.3 61.0 52.5 50.5 48.8 44.6 44.9 -Crafts and trades 49 45 34.3 28.3 24.2 23.8 21.8 20.1 20.6 -Housing, utilities and public services 33 33 30.5 28.3 23.8 23.3 23.5 24.1 24.4 -Financial and other services 64 69 61.0 55.4 50.7 51.5 50.1 51.3 64.3 Education, health and government 249 269 266.9 250.6 234.1 236.1 234.5 234.5 229.9 Education, culture and the arts 92 100 98.8 93.8 87.7 88.9 89.4 88.8 89.4 Health care and social services 95 107 107.4 101.9 97.4 98.6 97.3 95.3 92.6 Central and local gov.bodies, funds, associations & org. 62 62 59.3 54.4 48.6 48.2 47.5 50.4 47.9 Workers employed in the crafts and trades sector 1/ 42 51 58.0 129.0 123.4 130.5 149.2 168.7 182.7

Source: Central Bureau of Statistics 1/ Since 1991 includes self-employed individuals. 21 Does not include ministries of Defense and Interior. Table 2.4. Croatia: Distribution of average annual unemployed persons according to sex and qualification 1984 1985 1986 1987 1988 1989 1999 1991 1992 1993 1994 1995 1996

Unemployed 100 100 100 100 100 100 100 100 100 100 100 100 100

Women (%) 61.5 61.7 61.3 61.0 59.3 59.6 61.9 52.5 53.0 55.2 53.6 51.6 50.5 Men (%) 38.5 38.3 38.7 39.0 40.7 40.4 38.1 47.5 47.0 44.8 46.4 48.4 49.5

Unskilled (%) 24.7 24.5 24.4 23.6 22.2 21.4 21.5 20.3 19.2 19.8 21.4 21.4 21.2 72.7 Of which Women (%) 63.1 62.8 61.9 61.5 59.6 60.1 57.6 56.3 57.4 59.4 56.8 Of which Men (%) 36.9 37.2 38.1 38.5 40.4 39.9 42.4 43.7 42.6 40.6 43.2 27.3

Semiskilled, Elementary School (%) 16.0 15.5 15.4 14.7 14.8 14.7 15.2 17.0 16.8 16.0 15.2 14.9 14.6 49.2 Of which Women (%) 60.7 59.9 58.5 57.1 55.1 54.3 84.3 49.5 51.0 52.9 50.8 Of which Men (%) 39.3 40.1 41.5 42.9 44.9 45.7 15.7 50.5 49.0 47.1 49.2 50.8

Skilled, Highly Skilled: 26.2 27.1 28.1 29.7 30.7 30.3 30.3 32.2 32.5 32.2 32.6 34.1 34.9 Of which Women (%) 47.7 48.6 48.9 49.5 47.5 48.0 45.4 40.1 40.8 43.2 42.3 40.9 Ofwhich Men (%) 52.3 51.4 51.1 50.5 52.5 52.0 54.6 59.9 59.2 56.8 57.7 59.1

Secondary School (%) 23.3 23.3 22.8 22.6 22.7 23.9 23.5 21.6 22.5 23.3 23.1 22.7 22.5 Of which Women (%) 76.5 77.1 77.2 77.3 76.2 75.5 72.3 68.0 67.2 69.1 67.8 66.6 Of which Men (%) 23.5 22.9 22.8 22.7 23.8 24.5 27.7 32.0 32.8 30.9 32.2 33.4

Vocational Training (%) 4.1 4.3 4.2 4.2 4.3 4.2 4.0 3.7 3.8 3.8 3.5 3.1 3.0 Of which Women (%) 57.4 60.6 62.3 62.7 63.7 64.4 63.6 56.9 56.4 55.4 54.0 53.7 Of which Men (%) 42.6 39.4 37.7 37.3 36.3 35.6 36.4 43.1 43.6 44.6 46.0 46.3

University (%) 5.7 5.3 5.0 5.2 5.2 5.4 5.5 5.2 5.2 4.9 4.3 3.9 3.8 Of which Women (%) 62.0 62.7 62.7 62.3 62.3 63.0 61.6 56.1 56.1 57.3 57.0 57.8 Of which Men (%) 38.0 37.3 37.3 37.7 37.7 37.0 38.4 43.9 43.9 42.7 43.0 42.2

Source: Central Bureau of Statistics of Croatia and World Bank. Table 2.5. Croatia: Distribution of unemployed persons according to age

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

Unemployed 100 100 100 100 100 100 100 100 100 100 100 100

Less than 18 years 12.6 12.6 11.0 10.2 9.2 9.1 3.1 1.9 1.8 1.7 7.7 7.9 19-24 53.9 54.4 54.2 53.6 52.5 52.2 43.0 35.0 32.7 30.3 25.9 26.2 25-29 13.6 13.4 14.4 15.2 16.5 14.0 20.2 19.8 19.2 18.6 17.9 17.1 30-39 11.1 11.2 12.0 12.4 13.1 16.0 19.4 24.2 25.4 26.1 25.4 25.3 40-49 6.1 5.8 5.6 5.5 5.6 5.5 8.5 12.3 13.8 15.6 15.9 16.6 50 and more years 2.6 2.6 2.9 3.0 3.2 3.2 5.7 6.9 7.2 7.7 7.3 7.0

Source: Central Bureau of Statistics of Croatia and World Bank.

00 Table 3.1. Croatia: GDP at factor cost according to UCEA Current Prices (in millions of Kunas) Percentage Composition 1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1994 1995

Total GDP at factor costs 252.7 373.9 2,294.0 36,023.0 68,262.5 74,837.9 100 100 100 100 100 100 Net Indirect Taxes 26.3 33.8 333.6 5,808.2 17,036.5 19,726.1 10.4 9.0 14.5 16.1 25.0 26.4 GDP mp 279.0 407.7 2,627.6 41,831.2 85,299.0 94,564.0 110.4 109.0 114.5 116.1 125.0 126.4 1 Industry and mining 64.5 96.1 580.1 9,007.2 14,933.9 14,889.1 25.5 25.7 25.3 25.0 21.9 19.9 2 Agriculture and fisheries 23.6 35.4 290.3 4,171.6 8,097.0 8,380.4 9.3 9.5 12.7 11.6 11.9 11.2 3 Forestry 2.8 4.9 32.3 461.7 934.0 885.5 1.1 1.3 1.4 1.3 1.4 1.2 4 Water management 0.9 1.6 6.0 97.3 194.1 200.2 0.4 0.4 0.3 0.3 0.3 0.3 5 Construction 14.6 18.7 69.6 1,277.6 2,615.2 2,949.9 5.8 5.0 3.0 3.5 3.8 3.9 6 Transport and communications 22.1 38.6 158.8 2,381.5 5,077.4 5,498.8 8.7 10.3 6.9 6.6 7.4 7.3 7 Trade 22.1 35.7 231.1 2,733.8 5,019.2 6,123.4 8.7 9.6 10.1 7.6 7.4 8.2 8 Hotels, restaurants and tourism 12.4 9.7 81.8 1,158.1 2,738.9 2,511.5 4.9 2.6 3.6 3.2 4.0 3.4 9 Crafts and personal services 8.6 12.7 60.2 891.9 2,227.1 2,872.9 3.4 3.4 2.6 2.5 3.3 3.8 10 Housing, utilities and public services 16.0 33.4 242.1 4,803.0 5,772.7 6,207.6 6.3 8.9 10.6 13.3 8.5 8.3 -utilities 4.5 6.7 27.5 451.6 961.1 1,006.2 1.8 1.8 1.2 1.3 1.4 1.3 -housing rent 11.5 26.7 214.6 4,351.4 4,811.6 5,201.3 4.6 7.1 9.4 12.1 7.0 7.0 11 Financial and other services 9.7 22.2 169.4 2,904.9 6,562.3 6,844.5 3.9 5.9 7.4 8.1 9.6 9.1 12 General government services 55.4 65.0 372.3 6,134.5 14,090.8 17,464.2 21.9 17.4 16.2 17.0 20.6 23.3 -education and culture 20.1 24.3 105.0 1,745.8 4,245.8 4,971.9 8.0 6.5 4.6 4.8 6.2 6.6 -health care and social services 18.4 23.0 101.4 1,667.3 3,798.1 4,933.8 7.3 6.1 4.4 4.6 5.6 6.6 -public service and NGOs 16.9 17.7 166.0 2,721.4 6,046.9 7,558.6 6.7 4.7 7.2 7.6 8.9 10.1

Source: State Institute for Macroeconomic Analysis and Forecasting (SIMAF) Table 3.2. Croatia: GDP at factor cost according to UCEA 1994 Constant Prices (in millions of Kuna) Growth Rates 1990 1991 1992 1993 1994 1995 1996 1991 1992 1993 1994 1995 1996

Total GDP at factor costs 93,585 77,373 70,404 67,947 68,262 69,838 72,739 -17.3 -9.0 -3.5 0.5 2.3 4.2 Net Indirect Taxes 10,344 6,920 12,124 12,536 17,037 17,721 -33.1 75.2 3.4 35.9 4.0 GDP mp 103,928 84,293 82,528 80,483 85,299 87,559 -18.9 -2.1 -2.5 6.0 2.6 1 Industry and mining 24,044 18,033 15,905 15,317 14,934 14,979 15,454 -25.0 -11.8 -3.7 -2.5 0.3 3.2 2 Agriculture and fisheries 9,989 9,180 7,922 8,271 8,097 8,178 8,299 -8.1 -13.7 4.4 -2.1 1.0 1.5 3 Forestry 1,527 1,191 897 838 934 873 920 -22.0 -24.7 -6.6 11.5 -6.5 5.4 4 Water management 232 199 192 192 194 196 203 -14.0 -3.5 0.0 1.0 1.2 3.3 5 Construction 4,551 3,245 2,947 2,696 2,615 2,565 3,289 -28.7 -9.2 -8.5 -3.0 -1.9 28.2 6 Transport and communications 5,573 5,016 5,076 4,706 5,077 5,077 5,340 -10.0 1.2 -7.3 7.9 0.0 5.2 7 Trade 0 11,110 9,277 6,865 5,272 5,019 6,123 6,392 -16.5 -26.0 -23.2 -4.8 22.0 4.4 8 Hotels, restaurants and tourism 5,838 2,715 2,440 2,123 2,739 2,438 3,215 -53.5 -10.1 -13.0 29.0 -11.0 31.9 9 Crafts and personal services 2,492 2,043 1,927 2,015 2,227 2,450 2,528 -18.0 -5.7 4.6 10.5 10.0 3.2 10 Housing, utilities and public services 6,015 5,888 5,732 5,735 5,773 5,774 5,835 -2.1 -2.6 0.1 0.6 0.0 1.1 - utilities 1,247 1,157 973 953 961 957 961 -7.2 -15.9 -2.1 0.9 -0.4 0.4 - housing rent 4,769 4,731 4,759 4,783 4,812 4,816 4,874 -0.8 0.6 0.5 0.6 0.1 1.2 11 Financial and other services 7,933 7,203 6,591 6,696 6,562 6,766 6,580 -9.2 -8.5 1.6 -2.0 3.1 -2.7 12 General government services 14,280 13,384 13,910 14,085 14,091 14,419 14,683 -6.3 3.9 1.3 0.0 2.3 1.8 -education and culture 4,686 4,452 4,162 4,221 4,246 4,271 4,307 -5.0 -6.5 1.4 0.6 0.6 0.8 -health care and social services 4,191 3,978 3,803 3,848 3,798 3,798 3,824 -5.1 -4.4 1.2 -1.3 0.0 0.7 -public service and NGOs 5,403 4,955 5,945 6,017 6,047 6,349 6,553 -8.3 20.0 1.2 0.5 5.0 3.2

Source: State Institute for Macroeconomic Analysis and Forecasting (SIMAF) 111

Table 3.3. Croatia: GDP by Expenditures at Current Market Prices (In millions of Kunas) 1990 1991 1992 1993 1994 1995 1996

GDP at market prices 279 408 2,628 41,831 85,299 94,564 103,610 Net indirect taxes 26 34 334 5,808 17,037 19,726 20,534 GDP at factor cost 253 392 2,294 36,023 68,262 74,838 83,076

Resource Balance -13 148 -462 -1,383 -11,779 -11,869 Exports (GNFS) 343 1,614 20,434 39,290 38,072 43,515 Imports (GNFS) 355 1,466 20,896 40,672 49,851 55,384

Total expenditures 420 2,479 42,293 86,681 106,343 115,479

Consumption expenditures 374 2,116 36,265 75,046 92,986 100,145 Government 104 644 9,158 23,535 31,074 31,474 Private 270 1,473 27,107 51,511 61,912 68,671

Gross Domestic Investment 46 363 6,028 11,636 13,357 15,334 Government 3 44 661 3,056 3,982 6,198 Private 43 319 5,367 8,580 9,375 9,136 Total fixed investment 46 363 6,028 11,636 13,357 15,334 Total investment in stocks 0 0 0 0 0 0

Domestic saving 33 512 5,566 10,253 1,578 3,465 + Net factor income (NFY) -2 -45 -505 -747 -488 -247 + Net current transfers (NCT) 0 116 1,345 2,754 3,378 4,232 = National saving 31 582 6,406 12,261 4,468 7,451

Gross National Product 405 2,582 41,326 84,552 94,076 103,363 Gross National Disposable Income 405 2,698 42,671 87,307 97,454 107,596

Total GDP (million current USS) 12,354 9,942 11,693 14,226 18,081 19,067 Conversion factor used (LCU/US$) 0.03 0.26 3.58 6.00 5.23 5.43 Per capita gross national product 2,580 2,079 2,447 2,978 3,786 3,992 Population 4,770 4,789 4,782 4,779 4,777 4,776 4,776

Source: State Institute for Macroeconomic Analysis and Forecasting (SIMAF) and World Bank estimates. 112

Table 3.4. Croatia: GDP by Expenditures at Current Market Prices (percentage composition at current prices) 1991 1992 1993 1994 1995 1996

GDP at market prices 100 100 100 100 100 100 Net indirect taxes 8.3 12.7 13.9 20.0 20.9 19.8 GDP at factor cost 96.1 87.3 86.1 80.0 79.1 80.2

Resource Balance -3.1 5.6 -1.1 -1.6 -12.5 -11.5 Exports (GNFS) 84.0 61.4 48.8 46.1 40.3 42.0 Imports (GNFS) 87.2 55.8 50.0 47.7 52.7 53.5

Total expenditures 103.1 94.3 101.1 101.6 112.5 111.5

Consumption expenditures 91.8 80.5 86.7 88.0 98.3 96.7 Government 25.5 24.5 21.9 27.6 32.9 30.4 Private 66.3 56.0 64.8 60.4 65.5 66.3

Gross Domestic Investment 11.3 13.8 14.4 13.6 14.1 14.8 Government 0.8 1.7 1.6 3.6 4.2 6.0 Private 10.5 12.1 12.8 10.1 9.9 8.8 Total fixed investment 11.3 13.8 14.4 13.6 14.1 14.8 Total investment in stocks 0.0 0.0 0.0 0.0 0.0 0.0

Domestic saving 8.2 19.5 13.3 12.0 1.7 3.3 + Net factor income (NFY) -0.6 -1.7 -1.2 -0.9 -0.5 -0.2 + Net current transfers (NCT) 0.1 4.4 3.2 3.2 3.6 4.1 = National saving 7.7 22.1 15.3 14.4 4.7 7.2

Gross National Product 99.4 98.3 98.8 99.1 99.5 99.8 Gross National Disposable Income 99.5 102.7 102.0 102.4 103.1 103.8 Source: State Institute for Macroeconomic Analysis and Forecasting (SIMAF) and World Bank estimates. 113

Table 3.5. Croatia: GDP by Expenditures at constant 1994 prices (In millions of 1994 Kunas) 1990 1991 1992 1993 1994 1995 1996

GDP at market prices 103,928 84,293 82,528 80,483 85,299 87,559 91,237 Net indirect taxes 10,344 6,920 12,124 12,536 17,037 17,721 GDP at factor cost 93,585 77,373 70,404 67,947 68,263 69,838

Resource Balance -9,692 424 -829 -1,383 -12,837 Exports (GNFS) 48,310 31,154 36,399 39,290 40,904 Imports (GNFS) 58,002 30,731 37,227 40,672 53,741

Total expenditures 93,985 82,104 81,312 86,681 100,307

Consumption expenditures 81,554 71,104 69,562 75,046 86,756 Government 25,824 21,918 19,770 23,535 28,895 Private 55,730 49,186 49,792 51,511 57,861

Gross Domestic Investment 12,432 11,000 11,750 11,636 13,551 Government 1,568 2,850 2,880 2,739 3,988 Private 10,864 8,150 8,870 8,897 9,563 Total fixed investment 12,432 11,000 11,750 11,636 13,551 Total investment in stocks 0 0 0 0 0

Domestic saving 2739.68 11424.1 10921 10253.3 803.4 Source: State Institute for Macroeconomic Analysis and Forecasting (SIMAF) and World Bank estimates:

Table 3.6. Croatia: GDP by Expenditures (growth rates) 1991 1992 1993 1994 1995 1996

GDP at market prices -18.9% -2.1% -2.5% 6.0% 2.6% 4.2% Net indirect taxes -33.1% 75.2% 3.4% 35.9% 4.0% GDP at factor cost -17.3% -9.0% -3.5% 0.5% 2.3%

Resource Balance -104.4% -295.6% 66.8% 828.5% Exports (GNFS) -35.5% 16.8% 7.9% 4.1% Imports (GNFS) -47.0% 21.1% 9.3% 32.1%

Total expenditures -12.6% -1.0% 6.6% 15.7%

Consumption expenditures -12.8% -2.2% 7.9% 15.6% Government -15.1% -9.8% 19.0% 22.8% Private -11.7% 1.2% 3.5% 12.3%

Gross Domestic Investment -11.5% 6.8% -1.0% 16.5% Government 81.7% 1.1% -4.9% 45.6% Private -25.0% 8.8% 0.3% 7.5% Total fixed investment -11.5% 6.8% -1.0% 16.5% Total investment in stocks

Domestic saving -4.4% -6.1% -92.2% Source: State Institute for Macroeconomic Analysis and Forecasting (SIMAF) and World Bank estimates. 114

Table 4.1. Croatia - Balance of Payments (USS millions at current prices) 1990 1991 1992 1993 1994 1995 1996 Exports of G&S 6,823.0 4,633.0 6,154.5 5,822.2 6,653.9 7,375.2 8,234.6 Exports of GNFSb 6,819.0 4,568.0 6,106.5 5,710.6 6,552.9 7,201.8 8,008.1 Merchandise 4,020.0 3,292.0 4,597.5 3,903.8 4,260.4 4,632.7 4,511.8 Non-factor services 2,799.0 1,276.0 1,509.D 1,806.8 2,292.5 2,569.1 3,496.3

Imports of G&S 7,311.0 5,233.0 5,765.1 6,094.1 7,009.9 9,733.3 10,465.6 Imports of GNFS 7,115.0 5,067.0 5,547.1 5,841.2 6,784.4 9,466.6 10,193.6 Merchandise 5,188.0 3,828.0 4,460.7 4,666.4 5,229.3 7,509.9 7,787.9 Non-factor services 1,927.0 1,239.0 1,086.4 1,174.8 1,555.1 1,956.7 2,405.7

Resources Balance -296.0 -499.0 559.4 -130.7 -231.5 -2,264.8 -2,185.5 Non-FactoT Services Balance 872.0 37.0 428.6 631.9 737.4 611.4 1,088.5 Non Factor Service: Receipts 2,799.0 1,276.0 1,515.0 1,806.8 2,292.5 2,569.1 3,496.2 Non Factor Service: Payments 1,927.0 1,239.0 1,086.4 1,174.8 1,555.1 1,957.7 2,407.7 Net Factor Income -192.0 -101.0 -170.0 -141.3 -124.5 -93.3 -45.5 Factor Income: Receipts 4.0 65.0 48.0 111.6 101.0 173.4 226.5 Factor Income: Payment 196.0 166.0 218.0 252.9 225.5 266.7 272.0 Total Interest Due 196.0 166.0 218.0 238.5 219.4 253.7 256.4 Other Factor Payments and discrepancies 0.0 0.0 0.0 14.4 6.1 13.0 15.6 Net private current transfers 1,549.0 -7.0 22.0 126.3 224.0 366.0 624.2 Current receipts, of which 1,808.0 187.0 138.0 299.2 340.2 505.5 736.1 Workers' remittances 1,808.0 187.0 138.0 299.2 340.2 505.5 736.1 Current payments 259.0 194.0 116.0 172.9 116.2 139.5 111.9 Net official current transfers -8.0 18.0 103.0 249.7 235.3 279.9 154.5 Current Account Balance 1,053.0 -589.0 520.4 104.0 103.3 -1,712.2 -1,452.4

Private investment (net) 0.0 0.0 25.0 74.3 97.6 80.5 348.9 Direct foreign investment 0.0 0.0 25.0 74.3 97.6 80.5 348.9 Portfolio investments 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Net LT' borrowing -210.0 -453.0 -314.0 -191.7 -136.7 -136.8 437.7 Disbursements 226.0 117.0 60.0 153.6 184.3 315.1 844.3 Repayments (scheduled) 436.0 570.0 374.0 345.3 321.0 451.9 406.6 Total principal repaid 333.0 367.0 208.0 169.3 141.0 351.9 406.6 Net adjustments to scheduled repayments 103.0 203.0 166.0 176.0 180.0 100.0 0.0 Net other LT inflowse Adjustments to scheduled debt service 330.1 404.1 291.3 251.7 258.8 340.4 71.7 Debt service not paid 330.1 404.1 291.3 251.7 258.8 340.4 71.7 Reduction in arrears/prepayments (-) Other capital flows -1,162.1 637.9 -362.3 235.2 360.3 1,820.2 1,004.1 Net short-term capital 26.9 -38.1 -27.3 97.2 9.8 469.9 -28.8 Net capital flows n.e.i.d -1,638.0 -370.0 134.0 62.2 248.8 49.8 210.7 Errors and omissions 449.0 1,046.0 -469.0 75.8 101.7 1,300.5 822.2

Change in net international reserves 0.0 0.0 -167.0 -473.6 -683.3 -395.0 -423.1 (- indicates increase in assets)

Memorandum items Total gross reserves, of which .. .. 166.8 616.4 1405 1895.2 2314 Total gross reserves (in months of imports G&Sf . .. 0.3 1.2 2.4 2.3 2.7 Exchange rates Annual average (Kuna/USS) 0.26 3.58 6.00 5.23 5.43 At end year (Kuna/USS) 0.80 6.56 5.63 5.32 5.54 Current Account Balance as %GDP -4.8 5.2 0.9 0.7 -9.5 -7.6 a. Does not include trade with the countries of former Yugoslavia b. Goods and nonfactor services. c. "LT" denotes "long-term." d. "n.e.i." denotes "not elsewhere included." e. "G & S" denotes "goods and services." Source: National Bank of Croatia (NBC) Table 4.2. Croatia: Exports by Destination

1990 1/ 1991 1992 2/ 1993 1994 1995 1996 1990 1/ 1991 1992 2/ 1993 1994 1995 1996

(In million of current dollars) (Percentage Composition)

TOTAL 2,913 3,292 4,597 3,904 4,260 4,633 4,512 100 100 100 100 100 100 100 EU 1,476 2,158 2,410 2,243 2,531 2,672 2,303 50.7 65.6 52.4 57.5 59.4 57.7 51.0 France 79 66 58 133 111 110 84 2.7 2.0 1.3 3.4 2.6 2.4 1.9 Italy 604 715 909 828 910 1,098 949 20.7 21.7 19.8 21.2 21.4 23.7 21.0 Netherlands 76 126 98 92 94 80 69 2.6 3.8 2.1 2.4 2.2 1.7 1.5 Germany 428 968 773 895 941 997 839 14.7 29.4 16.8 22.9 22.1 21.5 18.6 UK 75 57 56 73 68 57 70 2.6 1.7 1.2 1.9 1.6 1.2 1.6 Austria 84 97 105 130 149 200 198 2.9 2.9 2.3 3.3 3.5 4.3 4.4 Sweden 42 44 339 25 164 14 13 1.4 1.3 7.4 0.6 3.8 0.3 0.3 Others 87 85 72 65 94 115 81 3.0 2.6 1.6 1.7 2.2 2.5 1.8 EFTA 83 108 65 47 65 59 41 2.9 3.3 1.4 1.2 1.5 1.3 0.9 Switzerland 30 42 36 40 60 52 37 1.0 1.3 0.8 1.0 1.4 1.1 0.8 Others 53 66 30 7 1 2 3 1.8 2.0 0.6 0.2 0.0 0.0 0.1 OTHER DEVELOPED COUNTRIES 228 164 108 123 133 131 135 7.8 5.0 2.4 3.1 3.1 2.8 3.0

FORMERPLANNED ECONOMIES 677 390 1,736 1,270 1,336 1,475 1,582 23.2 11.8 37.8 32.5 31.4 31.8 35.1 East European Countries 677 390 265 304 368 415 363 23.2 11.8 5.8 7.8 8.6 8.9 8.0 CIS & Other EX USSR 498 247 155 173 176 185 172 17.1 7.5 3.4 4.4 4.1 4.0 3.8 Other 179 142 110 130 192 229 191 6.2 4.3 2.4 3.3 4.5 4.9 4.2 Former YU Republics 1,470 966 968 1,061 1,219 0.0 0.0 32.0 24.7 22.7 22.9 27.0 o/w.Slovenia 1,101 712 556 608 611 0 0 23.9 18.2 13.0 13.1 13.5 o/w. Bosnia-Herzegovina 338 383 549 7.9 8.3 12.2

LESS DEVELOPED COUNTRIES 441 395 163 190 195 295 452 15.1 12.0 3.5 4.9 4.6 6.4 10.0

1/Excludes exports of goods for processing. 2/ Includes exports to former Yugoslavia republics. Source: Central Bureau of Statistics Table 4.3. Croatia: Imports by Origin

1990" 1991 1992" 1993 1994 1995 1996 1990" 1991 1992" 1993 1994 1995 1996

(In million of current dollars) (Percentage Composition)

TOTAL 4,426 3,828 4,461 4,666 5,229 7,510 7,787 100 100 100 100 100 100 100 EU 2,138 2,126 2,106 2,622 3,096 4,664 4,625 48.3 55.5 47.2 56.2 59.2 62.1 59.4 France 96 99 72 97 116 188 199 2.2 2.6 1.6 2.1 2.2 2.5 2.6 Italy 675 623 761 882 994 1,366 1,421 15.2 16.3 17.1 18.9 19.0 18.2 18.2 Netherlands 130 115 89 92 115 174 176 2.9 3.0 2.0 2.0 2.2 2.3 2.3 Germany 672 833 768 991 1,110 1,509 1,602 15.2 21.8 17.2 21.2 21.2 20.1 20.6 UK 94 111 65 90 179 455 225 2.1 2.9 1.4 1.9 3.4 6.1 2.9 Austria 237 177 190 311 353 575 597 5.3 4.6 4.3 6.7 6.7 7.7 7.7 Sweden 75 46 53 60 81 148 117 1.7 1.2 1.2 1.3 1.6 2.0 1.5 Others 160 121 109 101 148 250 288 3.6 3.2 2.4 2.2 2.8 3.3 3.7

EFTA 161 119 90 94 112 219 179 3.6 3.1 2.0 2.0 2.1 2.9 2.3 Switzerland 95 87 67 79 101 169 144 2.2 2.3 1.5 1.7 1.9 2.2 1.8 Norway 8 44 0.0 0.0 0.0 0.0 0.2 0.6 0.0 Others 65 33 23 15 3 6 35 1.5 0.9 0.5 0.3 0.1 0.1 0.4 OTHER DEVELOPED COUNTRIES 370 322 193 232 312 417 457 8.4 8.4 4.3 5.0 6.0 5.6 5.9 , FORMER PLANNED ECONOMIES 903 575 1,635 1,267 1,130 1,547 1,690 20.4 15.0 36.6 27.1 21.6 20.6 21.7 East European Countries 903 575 604 494 558 697 824 20.4 15.0 13.5 10.6 10.7 9.3 10.6 CIS & Other EX USSR 432 253 231 261 254 224 253 9.8 6.6 5.2 5.6 4.9 3.0 3.2 Other 471 322 373 233 304 473 571 10.6 8.4 8.4 5.0 5.8 6.3 7.3 Former YU Republics 1,031 773 572 850 866 23.1 16.6 10.9 11.3 11.1 o/w. Slovenia 874 712 541 805 769 19.6 15.3 10.3 10.7 9.9 o/w. Bosnia-Herzegovina 9 63 0.1 0.8 0.0 0.0 0.0 LESS DEVELOPED COUNTRIES 803 654 426 432 546 663 836 18.1 17.1 9.5 9.3 10.4 8.8 10.7

1/ Excludes imports of goods for processing. 2/ includes imports from former Yugoslavia republics. Source: Central Bureau of Statistics Table 4.4. Croatia: Exports and Imports According to UCEA (in millions of US$)

1991a 1992 1993 1994 1995 1996 1991a 1992 1993 1994 1995 1996

EXPORTS IMPORTS

Total 3,292 4,597 3,904 4,260 4,633 4,512 3,828 4,461 4,666 5,229 7,510 7,788 Mining & Industry 3,168 4,389 3,780 4,154 4,497 4,388 3,274 3,948 4,183 4,579 6,724 7,076 Extraction of Crude Petrol. & Gas 25 56 28 22 38 46 539 347 377 477 709 742 Petroleum Products Industry 146 297 310 337 350 353 38 37 25 50 58 69 Iron & Steel Industry 100 114 55 60 48 37 59 145 155 132 208 233 Manufacture of Metal Products 108 144 127 130 148 154 102 200 168 205 350 378 Machine Industry 153 132 119 156 166 170 310 293 362 447 666 775 Manufacture of Transport Equipment 94 59 63 48 73 71 333 171 376 439 522 556 Shipbuilding 363 441 162 303 260 410 3 4 12 21 82 98 Manufacture of Electrical Equipment 160 241 221 253 312 338 229 278 406 513 815 813 Basic Chemical Industry 299 455 382 341 586 415 344 420 308 264 358 354 Chemical Products Industry 140 272 217 265 264 267 285 381 344 366 594 654 Timber Industry 98 149 161 140 150 154 11 25 26 28 39 70 Finished Wood Prod. Industry 140 135 181 174 185 143 7 33 30 55 94 101 Paper&PaperProducts 53 101 102 105 119 71 50 135 166 131 231 238 Textile Fibber & Fabric Industry 50 67 67 95 89 79 71 115 105 104 140 134 Finished Textile Prod. Industry 596 581 668 639 696 653 183 206 211 265 324 338 Leather Footwear & Access. Manufact. 172 194 235 310 254 253 159 299 367 222 244 272 Food Products Industry 177 325 277 324 320 344 192 325 .260 331 500 503 Beverage Industry 23 80 64 42 72 78 24 49 34 60 59 62 Other Industrial Branches 271 545 341 410 366 354 334 484 451 469 730 688 Agriculture & Fisheries 91 152 101 80 103 94 247 204 139 212 344 333 Forestry 23 30 16 23 29 27 4 5 5 7 9 9 Other 10 27 7 3 4 3 303 304 339 431 433 370

a. Does not include trade with the countries of former Yugoslavia Source: Central Bureau of Statistics 118

Table 4.5. Croatia: Imports and Exports by Main Commodity Group (in million of current dollars)

1990 1/ 19911 1992 2/ 1993 1994 1995 1996

Imports 4,426 3,828 4,461 4,666 5,229 7,510 7,786 Food Products 700 375 468 357 498 780 767 Beverage and Tobacco 37 22 52 37 62 66 58 Raw material Except Fuel 286 199 263 176 151 198 220 Fuel and Lubricants 860 667 430 461 589 871 857 Oils and fats 25 10 23 15 12 25 38 Chemical Products 600 515 672 575 541 810 848 Products classified by matter 576 347 808 804 801 1,304 1,384 Machines & Transport Equipment 933 840 726 1,123 1,367 2,009 2,129 Miscellaneous ready made products 400 551 715 780 776 1,013 1,117 Others 9 302 304 339 431 433 368

Exports 2,913 3,292 4,597 3,904 4,260 4,633 4,512 Food Products 267 246 459 367 398 395 411 Beverage and Tobacco 18 24 112 101 67 90 92 Raw material Except Fuel 189 171 286 237 214 251 247 Fuel and Lubricants 146 223 397 377 386 391 416 Oils and fats 3 1 6 4 7 9 10 Chemical Products 331 399 597 564 543 814 643 Products classified by matter 608 477 820 526 654 670 594 Machines & Transport Equipment 863 770 849 552 732 778 964 Miscellaneous ready made products 479 971 1,044 1,169 1,257 1,233 1,133 Others 7 10 28 7 3 2 2

1/ Excludes imports and exports of goods for processing. 2/ Includes imports from and exports to former Yugoslavia republics. Source: Central Bureau of Statistics 119

Table 5.1. Croatia: Central Government Budget (unconsolidated) (Millions of Kuna) 1991 1992 1993 1994 1995 1996

Revenue and grants 64 556 8,471 24,260 27,981 31,367 Revenue 64 556 8,471 24,260 27,881 31,367 Current revenue 64 546 8,371 23,906 27,287 30,244 Tax revenue 63 501 7,892 23,350 26,505 28,530 Personal Income tax 3,212 3,498 4,217 Profit tax 592 1,009 1,271 Income and profit tax 25 84 936 3,803 4,507 5,488 Property tax 0 2 63 118 142 172 Taxes on goods and services 33 316 5,663 15,894 17,746 18,873 o/w. General sales, or VAT 13,107 12,802 13,504 o/w. Excises 2,689 4,944 5,369 Taxes on international trade 5 99 1,230 3,487 3,939 3,965 Other tax revenue 0 0 0 49 172 33 Non-tax revenue 1 45 479 556 782 1,714 Entrepreneurial and property income 211 329 336 o/w NBC profit transfer 141 166 82 Administrative fees and charges 165 211 946 Fines and forfeits 111 188 229 Other non-tax 69 54 203 Capital revenue 0 10 100 354 594 1,123 Privatization 354 496 555 Sales of apartments 0 98 569 Grants 0 0 0 0 too 0

Expenditure and net lending 83 564 8,403 23,719 28,696 31,502 Expenditure 83 564 8,403 23,403 28,476 30,973 Current expenditure 80 520 7,742 21,194 25,495 25,930 Expenditure on goods and services 62 396 6,111 17,145 20,735 19,623 Wages and salaries 21 98 1,941 6,589 8,394 8,365 Employer contributions 4 24 484 1,383 1,716 1,966 Other goods and services 37 273 3,686 9,173 10,625 9,292 Interest payments 1 21 212 1,305 1,392 1,218 Domestic 1 21 207 1,132 911 950 External 0 0 5 173 481 268 Subsidies and other current transfers 17 103 1,419 2,744 3,369 5,089 Subsidies 1,753 1,810 2,077 Current transfers 992 1,559 3,012 Pension fund 1/ 0 280 1,100 Other 0 338 402 Capital expenditure 3 44 661 2,210 2,980 5,043 Lending minus repayments 2/ 0 0 0 316 221 529 Central budget current account balance v1 -16 27 629 2,713 1,892 4,314 Central budget overall balance 1' -19 -8 68 541 -715 -134

Financine -1,236 884 539 External -13 686 931 Domestic -1,223 198 -392 Source: Ministry of Finance and World Bank estimates Notes: 1/ Before consolidation 120

Table 5.2. Croatia: Central Government Budget (unconsolidated) (Percent of GDP) 1991 1992 1993 1994 1995 1996

Revenue and grants 15.7 21.2 20.3 28.4 29.6 30.4 Revenue 15.7 21.2 20.3 28.4 29.5 30.4 Current revenue 15.7 20.8 20.0 28.0 28.9 29.3 Tax revenue 15.5 19.1 18.9 27.4 28.0 27.6 Personal Income tax 0.0 0.0 0.0 3.8 3.7 4.1 Profits tax 0.0 0.0 0.0 0.7 1.1 1.2 Income and profit tax 6.1 3.2 2.2 4.5 4.8 5.3 Property tax 0.0 0.1 0.2 0.1 0.1 0.2 Taxes on goods and services 8.1 12.0 13.5 18.6 18.8 18.3 o/w. General sales, or VAT 0.0 0.0 0.0 15.4 13.5 13.1 o/w. Excises 0.0 0.0 0.0 3.2 5.2 5.2 Taxes on international trade 1.2 3.8 2.9 4.1 4.2 3.8 Other tax revenue 0.0 0.0 0.0 0.1 0.2 0.0 Non-tax revenue 0.2 1.7 1.1 0.7 0.8 1.7 Entrepreneurial and property income 0.2 0.3 0.3 o/w NBC profit transfer 0.2 0.2 0.1 Administrative fees and charges 0.2 0.2 0.9 Fines and forfeits 0.1 0.2 0.2 Other non-tax 0.1 0.1 0.2 Capital revenue 0.0 0.4 0.2 0.4 0.6 1.1 Privatization 0.4 0.5 0.5 Sales of apartments 0.0 0.1 0.6 Grants 0.0 0.0 0.0 0.0 0.1 0.0

Expenditure and net lending 20.2 21.4 20.1 27.8 30.3 30.5 Expenditure 20.2 21.4 20.1 27.4 30.1 30.0 Current expenditure 19.5 19.8 18.5 24.8 27.0 25.1 Expenditure on goods and services 15.2 15.1 14.6 20.1 21.9 19.0 Wages and salaries 5.2 3.7 4.6 7.7 8.9 8.1 Employer contributions 1.0 0.9 1.2 1.6 1.8 1.9 Other goods and services 9.1 10.4 8.8 10.8 11.2 9.0 Interest payments 0.1 0.8 0.5 1.5 1.5 1.2 Domestic 0.1 0.8 0.5 1.3 1.0 0.9 External 0.0 0.0 0.0 0.2 0.5 0.3 Subsidies and other current transfers 4.2 3.9 3.4 3.2 3.6 4.9 Subsidies 2.1 1.9 2.0 Current transfers 1.2 1.6 2.9 Pension fund 0.0 0.3 1.1 Other 0.0 0.4 0.4 Capital expenditure 0.7 1.7 1.6 2.6 3.2 4.9 Lending minus repayments 0.0 0.0 0.0 0.4 0.2 0.5 Central budget current account balance u -3.8 1.0 1.5 3.2 2.0 4.2 Central budget overall balance" -4.5 -0.3 0.2 0.6 -0.8 -0.1

Financing -1.4 0.9 0.5 External 0.0 0.7 0.9 Domestic -1.4 0.2 -0.4 Source: Ministry of Finance and World Bank estimates Notes: 1/ Before consolidation 121

Table 5.3. Croatia: Extra Budgetary Funds (Millions of kunas)

1991 1992 1993 1994 1995 1996

Consolidated Revenue 83 368 5743 14224 17808 20877 A. Central govt. contribution 10 54 915 2006 3042 2518 B. Own Revenue (1+11) 73 314 4829 12218 14604 18217 I. Tax revenue 70 299 4586 11344 13667 17193 Social Security Tax 61 260 3984 9530 11449 14826 a. Employees 46 202 2966 6931 8239 9557 b. Employers 12 45 809 2235 2702 4669 c. Self- employed 3 14 209 363 508 601 Others 9 39 602 1814 2217 2367 II. Non-Tax Revenue 3 15 242 873 937 1024 III. Capital Revenue 0 0 0 0 162 142

Consolidated Expenditure 84 456 6136 13530 17977 21283 1. Current Expenditure 84 456 6136 13231 17393 20486 1. Expenditure on Goods and Services 33 216 2609 5467 6814 7542 Wages and Salaries 8 51 638 1922 2728 2975 Other Purchase of goods and Services. 25 165 1971 3545 4086 4567 2. Interest Payment 0 0 1 6 8 17 3. Transfers 51 240 3527 7758 10572 12927 II. Capital Expenditure 0 0 0 294 584 797 III. Repayment 0 0 0 5 0 0

Consolidated Balance -1 -88 -393 694 -169 -406

A. Pension Fund Total Revenue 46 188 3,008 8,325 10,525 12,407 I. Central govt. contrib. & Inter-Fund Transf. 8 29 449 1,160 1,804 1,160 II. Tax revenue 35 146 2,337 6,881 8,335 10,951 a. Employees 21 87 1,378 3,799 4,711 5,267 b. Employers 13 57 928 2,640 3,239 5,267 c. Self- employed 0 0 5 180 237 293 e. Others 0 2 26 261 148 125 III. Non-Tax Revenue 3 13 221 284 223 155 IV. Capital Revenue 0 0 0 0 162 141

Total Expenditure 46 209 3,318 8,002 10,667 12,411 1. Current Expenditure 46 209 3,318 8,002 10,651 12,394 1. Expenditure on Goods and Services 3 16 252 379 478 428 Wages and Salaries 1 6 100 99 133 143 Employer's Contributions 0 0 3 22 24 27 Other Purchase of goods and Serv. 2 9 149 258 321 258 2. Interest Payments 0 0 1 4 2 1 3. Transfers 42 193 3,066 7,619 10,171 11,965 To other EBFs 1 0 7 1,295 1,782 1,925 To Household 41 193 3,059 6,305 8,355 10,002 Abroad 0 0 0 19 34 38 II. Capital Expenditure 0 0 0 0 16 18

Balance 0 -21 -310 323 -143 -4

B. Health Fund Total Revenue 32 150 2,452 5,942 7,602 8,751 I. Central govt. contrib. & Inter-Fund Transf. 5 26 485 2,167 3,044 3,330 II. Tax revenue 27 123 1,950 3,509 4,265 5,066 a. Employees 16 72 1,170 1,920 2,097 2,713 122

Table 5.3 (continued)

1991 1992 1993 1994 1995 1996

b. Employers 0 0 0 0 0 c. Self- employed 3 13 204 183 271 308 e. Others 9 37 576 1,406 1,896 2,045 III. Non-Tax Revenue 0 2 17 266 293 355 IV. Capital Revenue 0 0 0 0 0 0

Total Expenditure 34 223 2,693 5,636 7,593 8,924 I. Current Expenditure 34 223 2,693 5,636 7.528 8,737 1. Expenditure on Goods and Services 30 201 2,426 4,981 6,398 7,103 Wages and Salaries 6 44 539 1,810 2,580 2,807 Employer's Contributions 2 15 163 380 510 567 Other Purchase of goods and Serv. 22 141 1,725 2,790 3,308 3,729 2. Interest Payments 0 C 0 0 0 0 3. Transfers to households 3 22 267 655 1,130 1,634 II. Capital Expenditure 0 C 0 0 64 187

Balance -1 -72 -240 306 9 -173

C. Employment Fund Total Revenue 5 24 229 646 747 722 1. Central govt. contrib. & Inter-Fund Transf. 0 4 20 89 56 0 II. Tax revenue 5 21 209 543 657 700 III. Non-Tax Revenue 0 0 0 14 34 22 IV. Capital Revenue 0 0 0 0 0 0

Total Expenditure 5 24 172 536 583 833 I. Current Expenditure 5 24 172 536 583 803 1. Expenditure on Goods and Services 1 14 94 275 195 219 2. Interest Payments 0 0 0 0 0 0 3. Transfers 3 10 78 260 388 584 To other EBFs 2 6 59 120 137 157 To Household 1 4 19 141 251 427 II. Capital Expenditure 0 0 0 0 0 30

Balance 0 0 57 110 165 -111

D. Children Fund Total Revenue 4 23 214 689 782 879 I. Central govt. contrib. & Inter-Fund Transf. 0 0 0 0 0 0 II. Tax revenue 4 22 210 669 773 877 III. Non-Tax Revenue 0 0 4 20 9 1 IV. Capital Revenue 0 0 0 0 0 0

Total Expenditure 4 18 114 665 821 853 I. Current Expenditure 4 18 114 665 821 853 1. Expenditure on Goods and Services 0 0 3 27 19 28 2. Interest Payments 0 0 0 0 0 0 3. Transfers 4 17 111 638 802 825 To Household 4 17 Ill 638 802 825 II. Capital Expenditure 0 0 0 0 0 0

Balance 0 5 100 24 -38 25

E. Rent Compensation Total Revenue 1 5 72 0 0 0 I. Central govt. contrib. & Inter-Fund Transf. 0 2 26 0 0 0 II. Tax revenue 1 3 46 0 0 0 III. Non-Tax Revenue 0 0 0 0 0 0 IV. Capital Revenue 0 0 0 0 0 0 123

Table 5.3 (continued)

1991 1992 1993 1994 1995 1996

Total Expenditure 1 5 72 0 0 0 1. Current Expenditure 1 5 72 0 0 0 1. Expenditure on Goods and Services 0 0 0 0 0 0 2. Interest Payments 0 0 0 0 0 0 3. Transfers to households 1 5 72 0 0 1 II. Capital Expenditure 0 0 0 0 0 0 III. Repayment

Balance 0 0 0 - 0 0 0

F. Water Fund Total Revenue 441 608 798 I. Central govt. contrib. & Inter-Fund Transf. 5 58 110 II. Tax revenue 147 173 197 III. Non-Tax Revenue 289 378 490 IV. Capital Revenue 0 0 1

Total Expenditure 0 0 0 505 769 940 I. Current Expenditure 0 0 0 211 266 378 1. Expenditure on Goods and Services 0 0 0 210 260 362 2. Interest Payments 0 0 0 2 6 16 II. Capital Expenditure 0 0 0 294 503 563

Balance 0 0 0 -65 -161 -143

Source: Ministry of Finance and World Bank estimates 124

Table 5.4. Croatia: Extra Budgetary Funds (Percent of GDP)

1991 1992 1993 1994 1995 1996

Consolidated Revenue 20.4 14.0 13.7 16.7 18.8 20.2 A. Central govt. contribution 2.4 2.1 2.2 2.4 3.2 2.4 B. Own Revenue (1+11) 18.0 11.9 11.5 14.3 15.4 17.6 I. Tax revenue 17.1 11.4 11.0 13.3 14.5 16.7 Social Security Tax 14.9 9.9 9.5 11.2 12.1 14.4 a. Employees 11.3 7.7 7.1 8.1 8.7 9.3 b. Employers 2.9 1.7 1.9 2.6 2.9 4.5 c. Self- employed 0.7 0.5 0.5 0.4 0.5 0.6 Others 2.2 1.5 1.4 2.1 2.3 2.3 II. Non-Tax Revenue 0.8 0.6 0.6 1.0 1.0 1.0 III. Capital Revenue 0.0 0.0 0.0 0.0 0.2 0.1

Consolidated Expenditure 20.6 17.3 14.7 15.9 19.0 20.6 1. Current Expenditure 20.6 17.3 14.7 15.5 18.4 19.8 1. Expenditure on Goods and Services 8.1 8.2 6.2 6.4 7.2 7.3 Wages and Salaries 1.9 1.9 1.5 2.3 2.9 2.9 Other Purchase of goods and Services 6.2 6.3 4.7 4.2 4.3 4.4 2. Interest Payment 0.0 0.0 0.0 0.0 0.0 0.0 3. Transfers 12.6 9.1 8.4 9.1 11.2 12.5 II. Capital Expenditure 0.0 0.0 0.0 0.3 0.6 0.8 III. Repayment 0.0 0.0 0.0 0.0 0.0 0.0

Consolidated Balance -0.3 -3.3 -0.9 0.8 -0.2 -0.4

A. Pension Fund 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total Revenue (A+B) 11.2% 7.1% 7.2% 9.8% 11.1% 12.0% A. Central govt. contrib. & Inter-Fund Transf. 1.9% 1.1% 1.1% 1.4% 1.9% 1.1% B. Tax revenue 8.6% 5.6% 5.6% 8.1% 8.8% 10.6% a. Employees 5.2% 3.3% 3.3% 4.5% 5.0% 5.1% b. Employers 3.3% 2.2% 2.2% 3.1% 3.4% 5.1% c. Self- employed 0.0% 0.0% 0.0% 0.2% 0.3% 0.3% e. Others 0.1% 0.1% 0.1% 0.3% 0.2% 0.1% III. Non-Tax Revenue 0.7% 0.5% 0.5% 0.3% 0.2% 0.1% IV. Capital Revenue 0.0% 0.0% 0.0% 0.0% 0.2% 0.1%

Total Expenditure 11.2% 7.9% 7.9% 9.4% 11.3% 12.0% I. Current Expenditure 11.2% 7.9% 7.9% 9.4% 11.3% 12.0% 1. Expenditure on Goods and Services 0.8% 0.6% 0.6% 0.4% 0.5% 0.4% Wages and Salaries 0.3% 0.2% 0.2% 0.1% 0.1% 0.1% Employer's Contributions 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Other Purchase of goods and Serv. 0.5% 0.4% 0.4% 0.3% 0.3% 0.3% 2. Interest Payments 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 3. Transfers 10.4% 7.3% 7.3% 8.9% 10.8% 11.6% To other EBFs 0.2% 0.0% 0.0% 1.5% 1.9% 1.9% To Household 10.1% 7.3% 7.3% 7.4% 8.8% 9.7% Abroad 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% II. Capital Expenditure 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Balance 0.0% -0.8% -0.7% 0.4% -0.2% 0.0%

B. Health Fund 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total Revenue (A+B) 8.0% 5.7% 5.9% 7.0% 8.0% 8.5% A. Central govt. contrib. & Inter-Fund Transf. 1.2% 1.0% 1.2% 2.5% 3.2% 3.2% B. Tax revenue 6.7% 4.7% 4.7% 4.1% 4.5% 4.9% a. Employees 3.9% 2.7% 2.8% 2.3% 2.2% 2.6% b. Employers 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 125

Table 5.4 (continued)

1991 1992 1993 1994 1995 1996

c. Self- employed 0.7% 0.5% 0.5% 0.2% 0.3% 0.3% e. Others 2.1% 1.4% 1.4% 1.6% 2.0% 2.0% III. Non-Tax Revenue 0.1% 0.1% 0.0% 0.3% 0.3% 0.3% IV. Capital Revenue 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Total Expenditure 8.3% 8.5% 6.4% 6.6% 8.0% 8.6% I. Current Expenditure 8.3% 8.5% 6.4% 6.6% 8.0% 8.5% 1. Expenditure on Goods and Services 7.4% 7.6% 5.8% 5.8% 6.8% 6.9% Wages and Salaries 1.6% 1.7% 1.3% 2.1% 2.7% 2.7% Employer's Contributions 0.6% 0.6% 0.4% 0.4% 0.5% 0.5% Other Purchase of goods and Services 5.3% 5.4% 4.1% 3.3% 3.5% 3.6% 2. Interest Payments 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 3. Transfers to households 0.8% 0.8% 0.6% 0.8% 1.2% 1.6% II. Capital Expenditure 0.0% 0.0% 0.0% 0.0% 0.1% 0.2%

Balance -0.3% -2.7% -0.6% 0.4% 0.0% -0.2%

C. Employment Funds 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total Revenue (A+B) 1.2% 0.9% 0.5% 0.8% 0.8% 0.7% I. Central govt. contrib. & Inter-Fund Transf. 0.0% 0.1% 0.0% 0.1% 0.1% 0.0% II. Tax revenue 1.2% 0.8% 0.5% 0.6% 0.7% 0.7% III. Non-Tax Revenue 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% IV. Capital Revenue 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Total Expenditure 1.2% 0.9% 0.4% 0.6% 0.6% 0.8% I. Current Expenditure 1.2% 0.9% 0.4% 0.6% 0.6% 0.8% 1. Expenditure on Goods and Services 0.3% 0.5% 0.2% 0.3% 0.2% 0.2% 2. Interest Payments 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 3. Transfers 0.8% 0.4% 0.2% 0.3% 0.4% 0.6% To other EBFs 0.5% 0.2% 0.1% 0.1% 0.1% 0.2% To Household 0.3% 0.1% 0.0% 0.2% 0.3% 0.4% II. Capital Expenditure 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Balance 0.0% 0.0% 0.1% 0.1% 0.2% -0.1%

D. Children Fund 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total Revenue 1.1% 0.9% 0.5% 0.8% 0.8% 0.9% 1. Central govt. contrib. & Inter-Fund Transf. 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% II. Tax revenue 1.1% 0.9% 0.5% 0.8% 0.8% 0.8% 111. Non-Tax Revenue 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% IV. Capital Revenue 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Total Expenditure 1.0% 0.7% 0.3% 0.8% 0.9% 0.8% I. Current Expenditure 1.0% 0.7% 0.3% 0.8% 0.9% 0.8% 1. Expenditure on Goods and Services 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2. Interest Payments 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 3. Transfers 1.0% 0.6% 0.3% 0.7% 0.8% 0.8% To Household 1.0% 0.6% 0.3% 0.7% 0.8% 0.8% II. Capital Expenditure 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Balance 0.0% 0.2% 0.2% 0.0% 0.0% 0.0%

E. Rent Compensation 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total Revenue (A+B) 0.3% 0.2% 0.2% 0.0% 0.0% 0.0% I. Central govt. contrib. & Inter-Fund Transf. 0.1% 0.1% 0.1% 0.0% 0.0% 0.0% II. Tax revenue 0.2% 0.1% 0.1% 0.0% 0.0% 0.0% 111. Non-Tax Revenue 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% IV. Capital Revenue 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 126

Table 5.4 (continued)

1991 1992 1993 1994 1995 1996

Total Expenditure 0.3% 0.2% 0.2% 0.0% 0.0% 0.0% I. Current Expenditure 0.3% 0.2% 0.2% 0.0% 0.0% 0.0% 1. Expenditure on Goods and Services 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2. Interest Payments 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 3. Transfers 0.3% 0.2% 0.2% 0.0% 0.0% 0.0% II. Capital Expenditure 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% IHl. Repayment 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Balance 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

F. Water Fund Total Revenue 0.0% 0.0% 0.0% 0.5% 0.6% 0.8% I. Central govt. contrib. & Inter-Fund Transf. 0.0% 0.0% 0.0% 0.0% 0.1% 0.1% II. Tax revenue 0.0% 0.0% 0.0% 0.2% 0.2% 0.2% III. Non-Tax Revenue 0.0% 0.0% 0.0% 0.3% 0.4% 0.5% IV. Capital Revenue 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Total Expenditure 0.0% 0.0% 0.0% 0.6% 0.8% 0.9% I. Current Expenditure 0.0% 0.0% 0.0% 0.2% 0.3% 0.4% 1. Expenditure on Goods and Services 0.0% 0.0% 0.0% 0.2% 0.3% 0.4% 2. Interest Payments 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% II. Capital Expenditure 0.0% 0.0% 0.0% 0.3% 0.5% 0.5%

Balance 0.0% 0.0% 0.0% -0.1% -0.2% -0.1%

Source: Ministry of Finance and World Bank estimates 127

Table 5.5. Croatia: Local Governments (Millions of kunas)

1991 1992 1993 1994 1995

Revenue 16.01 74.17 1119.60 2704.29 2866.55 I. Other Central govt contribution 0.60 4.30 56.72 80.00 84.80 II. Tax revenue 14.69 66.88 1021.02 2512.91 2663.68 a. Profit Tax 1.15 6.64 108.19 264.64 280.52 b. Personal Income tax 11.69 55.12 821.22 1897.46 2011.31 c. Other Tax 1.85 5.11 91.61 350.81 371.86 III. Non-Tax Revenue 0.72 3.00 41.87 111.38 118.06

Expenditure 15.22 68.25 1119.60 2704.29 2866.55 I. Current Expenditure 15.22 68.25 1119.60 2463.61 2611.42 1. Expenditure on Goods and Services 15.22 68.25 1119.60 2463.61 2611.42 Wages and Salaries 3.38 14.82 237.06 564.01 597.85 Employer's Contributions 1.35 7.50 148.05 149.93 158.92 Other Purchase of goods and Serv. 10.48 45.93 734.50 1749.68 1854.66 2. Interest Pyments 0.00 0.00 0.00 0.00 0.00 3. Subsidies and Transfers 0.00 0.00 0.00 0.00 0.00 II. Capital Expenditure 0.00 0.00 0.00 240.68 255.12 III. Repayment Overall Balance 0.80 5.92 0.00 0.00 0.00

Source: Ministry of Finance and World Bank estimates

Table 5.6. Croatia: Local Governments (Percentage of GDP)

1991 1992 1993 1994 1995

Revenue 3.93 2.82 2.68 3.17 3.03 1. Other Central govt contribution 0.15 0.16 0.14 0.09 0.09 II. Tax revenue 3.60 2.55 2.44 2.95 2.82 a. Profit Tax 0.28 0.25 0.26 0.31 0.30 b. Personal Income tax 2.87 2.10 1.96 2.22 2.13 c. Other Tax 0.45 0.19 0.22 0.41 0.39 111. Non-Tax Revenue 0.18 0.11 0.10 0.13 0.12

Expenditure 3.73 2.60 2.68 3.17 3.03 I. Current Expenditure 3.73 2.60 2.68 2.89 2.76 1. Expenditure on Goods and Services 3.73 2.60 2.68 2.89 2.76 Wages and Salaries 0.83 0.56 0.57 0.66 0.63 Employer's Contributions 0.33 0.29 0.35 0.18 0.17 Other Purchase of goods and Serv. 2.57 1.75 1.76 2.05 1.96 2. Interest Pyments 0.00 0.00 0.00 0.00 0.00 3. Subsidies and Transfers 0.00 0.00 0.00 0.00 0.00 II. Capital Expenditure 0.00 0.00 0.00 0.28 0.27 III. Repayment 0.00 0.00 0.00 0.00 0.00 Overall Balance 0.20 0.23 0.00 0.00 0.00

Source: Ministry of Finance and World Bank estimates Table 5.7. Croatia: Consolidated General Government

1991 1992 1993 1994 1995 1996 1991 1992 1993 1994 1995 1996 (In millions of Kunas) (In percent of GDP)

Central budgetary government 1/ 2/ Revenues and grants 63.8 557.1 8470.9 24,260 27,981 31,367 15.6 21.2 20.2 28.4 29.6 30.3 Current revenues 23,906 27,287 30,244 28.0 28.9 29.2 Capital revenues 354 594 1,123 0.4 0.6 1.1 Grants 0 100 0 0.0 0.1 0.0 Expenditures and net lending 70 499.8 7482 22,112 26,189 27,592 17.2 19.0 17.9 25.9 27.7 26.6 Current expenditure 19,597 23,046 22,187 23.0 24.4 21.4 Capital expenditure 2,204 2,923 4,939 2.6 3.1 4.8 Net lending 311 221 467 0.4 0.2 0.5 Balance -6.2 57.3 988.9 2,148 1,791 3,776 -1.5 2.2 2.4 2.5 1.9 3.6

Extrabudgetary funds 2/ 31 Revenues and grants 75.1 315.3 4848.9 12,622 15,302 17,029 18.4 12.0 11.6 14.8 16.2 16.4 Current revenues 12,622 15,140 16,882 14.8 16.0 16.3 Capital revenues 0 162 142 0.0 0.2 0.1 Grants 0 0 5 0.0 0.0 0.0 Expenditures and net lending 89.7 477.4 6163.3 13529 17976 21282 22.0 18.2 14.7 15.9 19.0 20.5 Current expenditure 13230 17392 20485 15.5 18.4 19.8 Capital expenditure 294 584 797 0.3 0.6 0.8 " Net lending 5 0 0 0.0 0.0 0.0 Balance -14.6 -162.1 -1314.4 -907 -2674 -4253 -3.6 -6.2 -3.1 -1.1 -2.8 -4.1

Consolidated central government 2/ 4/ Revenues and grants 138.9 872.4 13319.8 36882 43283 48397 34.1 33.2 31.8 43.2 45.8 46.7 Current revenues 36529 42427 47126 42.8 44.9 45.5 Capital revenues 354 756 1265 0.4 0.8 1.2 Grants 0 100 5 0.0 0.1 0.0 Expenditures and net lending 159.7 977.2 13645.3 35642 44165 48874 39.2 37.2 32.6 41.8 46.7 47.2 Current expenditure 32827 40438 42671 38.5 42.8 41.2 Capital expenditure 2499 3506 5736 2.9 3.7 5.5 Net lending 316 221 467 0.4 0.2 0.5 Balance -20.8 -104.8 -325.5 1241 -883 -477 -5.1 -4.0 -0.8 1.5 -0.9 -0.5

Sources: Ministry of Finance, National Bank of Croatia, and staff estimates.

1/ Includes the Croatian Roads Fund. 2/ Revenues and expenditures adjusted for inter-governmental transfers. 3/ Composed of the Pension, Health, Employment, Child Benefits, and Water Management funds. Does not include the Privatization fund. 4/ Does not include local governments. Table 5.8. Croatia: Estimated Reconstruction Needs (Millions of Kuna) 1995 1996 1997 1998 1999 2000 Total for the period

Housing 800 2500 2500 2000 500 500 8800 Economy 590 650 1100 1100 1100 1100 5640 Buildings etc. 30 150 400 400 400 400 1780 Family farms and enterpr. 100 300 500 500 500 500 2400 Companies 460 200 200 200 200 100 1360 State Infrastructure 1190 1210 1290 860 420 410 5380 Electricity 300 300 300 300 50 50 1300 Mail and telecommunication 300 200 200 100 30 20 850 Railroads 100 200 200 100 100 100 800 Roads 100 100 200 100 50 50 600 Radio and television 20 20 10 10 - - 60 Water management 100 100 200 100 100 100 700 Forests 20 30 30 30 20 20 150 Oil 200 200 100 100 50 50 700 Airports 30 30 20 - - - 80 Waterways and ports 20 30 30 20 20 20 140 Local infrastructure 50 150 250 200 200 200 1050 Water supply 20 50 100 100 100 100 470 Sewage 10 50 100 50 50 50 310 Roads 20 50 50 50 50 50 270 Social infrastructure 310 300 400 370 370 370 2120 Schools, kindergardens, universities 100 100 200 100 50 50 600 Social welfare 20 30 30 50 50 50 230 Health 100 100 100 100 100 100 600 Government and judiciary 30 20 20 50 100 100 320 Cultural monuments heritage 30 20 20 50 100 100 320 Churches and cultural objects 30 30 30 50 50 50 210

Total 2940 4810 5540 4530 2590 2480 Total cumulative 2940 7750 13290 17820 20410 22890 22890 Source: Ministry of Finance and World Bank estimates Table 6.1. Croatia: Monetary Aggregates (in millions of Kunas) (as a percentage of GDP) 2i

1991 " 19921/ 1993 1994 1995 1996 1992" 1993 1994 1995 1996

ASSETS 1. Foreign assets (net) -24 -474 -1,962 1,136 3,025 7,292 -9.5 -2.9 -0.5 2.2 5.0 2. Domestic credit 245 5,880 39,357 42,939 47,634 52,539 116.6 54.1 48.2 47.9 48.3 2.1. Claims on central government and funds (net) 19,069 15,625 15,156 14,633 0.0 22.8 20.3 16.3 14.4 2.2. Claims on other domestic sectors 20,262 27,222 32,347 37,729 0.0 24.2 27.8 31.5 33.8 2.3. Claims on other banking institutions 10 30 31 38 0.0 0.0 0.0 0.0 0.0 2.4. Claims on nonbank financial institutions 16 62 101 139 0.0 0.0 0.0 0.1 0.1 Total (1+2) 221 5,406 37,395 44,074 50,659 59,832 107.1 51.2 47.8 50.1 53.3

LIABILITIES

1. Money (MI) 65 390 3,134 6,641 8,275 11,409 8.7 4.2 5.7 7.9 9.5 2.Savings and time deposits 26 235 1,466 1,867 2,038 3,255 5.0 2.0 2.0 2.1 2.6 Domestic Money (M2) 92 625 4,600 8,508 10,313 14,664 13.6 6.2 7.7 10.0 12.1 3. Foreign currency deposits 54 352 5,412 8,775 14,099 21,802 7.7 6.9 8.3 12.1 17.3 Broad Money 146 977 10,012 17,283 24,412 36,466 21.4 13.1 16.0 22.0 29.4 4_ Bonds and money market instruments 48 199 125 130 0.0 0.1 0.1 0.2 0.1 5. Restricted and blocked deposits 17 2,290 14,263 12,122 10,711 8,301 43.9 19.8 15.5 12.1 9.2 o/w: Households' blocked f/c deposits 13,857 11,471 9,812 7,168 0.0 16.6 14.8 11.3 8.2 6. Other items (net) 58 2,140 13,072 14,470 15,411 14,935 41.8 18.2 16.1 15.8 14.6 Total (1+2+3+4+5+6) 221 5,406 37,395 44,074 50,659 59,832 107.1 51.2 47.8 50.1 53.3

Source: NBC and World Bank Note: 1) Not strictly comparable with future years due to methodological changes. 2) Average stocks divided by GDP. 3) Official data show 33,311, following the transfer of non-performing loans of a large bank to the Bank Rehabilitation Agency