ZAGREB, 12 Dec (Hina) - Croatia's economy continues to grow rapidly, at a rate that remains among the highest in the euro area, but imbalances are emerging, as demand-side pressures driven by higher fiscal deficits contribute to rising inflation and a wider current account deficit, the IMF said in a report.
The Executive Board of the International Monetary Fund (IMF) has concluded the 2025 Article IV consultation with the Republic of Croatia, endorsing the staff appraisal without a meeting on a lapse-of-time basis, the IMF said on Thursday, as reported by the Croatian National Bank (HNB).
Under Article IV of the IMF's Articles of Agreement, the Fund holds bilateral discussions with member countries, usually every year. An IMF staff team visits the country to collect economic and financial information and to discuss recent developments and policy priorities with officials. After returning to headquarters, staff prepare a report which forms the basis for the Executive Board's discussion.
Given the unfavourable external environment and elevated global uncertainty, the IMF projects that Croatia's economic growth will moderate but still achieve a solid rate of around 3% in 2025 and 2026, while inflation is expected to move towards the ECB's target by late 2026 or early 2027.
The IMF also notes that the current account deficit is expected to widen in the short run before improving while the fiscal deficit is projected to average marginally below 3% of GDP during the projection horizon.
Inflation-related risks are rising
The IMF finds that risks to growth are broadly balanced while risks to inflation are tilted to the upside. Growth would be weaker if external demand, particularly in the tourism sector, were to weaken considerably, including because of worsening geopolitical or trade tensions, or lower growth of major trading partners. Global shocks could also result in higher inflation, notably through energy and food prices.
Domestically, there is a risk of protracted overheating, as continuation of accommodative fiscal policy and higher-than-expected wage and credit growth could fuel domestic demand and stall disinflation. On the upside, faster implementation of reforms could ease supply side constraints, raising actual and potential growth.
Recommendations to reduce inflation
Stronger and faster fiscal consolidation is key to dampening domestic demand pressures and reducing inflation, thereby addressing the emerging imbalances early on. It is also essential for strengthening the country's competitiveness and building buffers against future shocks and large spending needs.
In the short term, restraint in public salary growth, improving VAT compliance, ending the remaining cost of living support measures, and strengthening fiscal discipline at local government units can underpin the consolidation.
Over the medium term, there is considerable scope to broaden the tax base and improve the tax system, notably through reviewing and rationalising VAT exemptions and reduced rates and moving to value-based taxation on property.
On expenditure, measures should focus on (i) reducing the high wage bill building on a review of public sector employment; (ii) improving the efficiency of spending, notably healthcare and education spending, and better targeting social spending; and (iii) ensuring pension sustainability, notably by extending the effective retirement age.
The authorities should continue to strengthen corporate governance of state-owned enterprises and enhance public investment management, the IMF recommends.
Banking system remains highly liquid
The IMF assesses that cyclical systemic risks have risen but remain moderate and manageable, as the banking system remains highly profitable, well capitalised, and highly liquid.
Stress tests suggest that it would remain overall resilient under adverse scenarios. Further vigilance remains nonetheless warranted given the buildup of vulnerabilities and risks, particularly in the housing sector, as well as structural risks including relatively high sovereign-bank nexus and concentration of corporate loans.
The Croatian authorities appropriately tightened macroprudential policy through capital and borrower-based measures. As macro-financial conditions evolve, they should continue to monitor the macroprudential stance and adjust if warranted. In particular, tightening of the borrower-based measures might be needed in case cyclical risks persist.
Taxation of property and short-term rental income recommended
Given the high share of cash-financed property acquisition and foreign demand, complementary measures to boost housing supply and reduce speculative demand, notably through strengthening taxation on property and short-term rental income, are highly recommended.
Fostering potential growth in the context of population aging, labor shortages and skill mismatches, as well as subdued productivity, calls for healthcare and education reforms to boost human capital without increasing costs.
Healthcare reform needs to reduce geographical inequality in healthcare access, promote prevention and healthy living, review the central role of hospitals in the system, and improve the use and distribution of pharmaceuticals. Education reform should aim at reducing skills mismatches, complemented by measures to increase participation in adult learning. Better integration of foreign labor would magnify its role in supporting growth and welfare, the IMF report concludes.
