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 ........................................................................................................................