Guy Norton in Zagreb
February 17, 2012
Croatia's new centre-left coalition government had been hoping that the spending cuts outlined in its draft budget proposal would be enough to retain its investment grade credit ratings and maintain investor confidence. But on February 15, Fitch Ratings poured cold water on this.
The draft budget, sent to parliament on February 13 for approval, envisages nominal spending cuts of HRK3.6bn (€480m), which should help trim Croatia's budget deficit to 2.8% of GDP this year, down sharply on the end-2011 figure of 5.5% of GDP. Among the headline cuts, the government plans to shave HRK1.95n off the country's public sector wage bill by reducing overtime payments and slashing temporary employment contracts, while subsidies to the agriculture sector and the state railway company HZ will be cut by HRK817m and HRK543m respectively.
On the revenue side, the government is looking to raise as much as HRK3.5bn by raising VAT rate from 23% to 25% and is hoping to garner HRK2bn from privatisations, including the sale of stakes in insurer Croatia Osiguranje and savings bank HPB. On the borrowing front, Croatia is looking to raise at least $1.3bn through international bond sales in Japan and the US.
Commenting on the government's financing plans, Prime Minister Zoran Milanovic told state news agency Hina: "This is not the ideal budget proposal, but it's the best we could do. This budget will not lead to an explosion in investment, but without the adopted measures we can't move forward."
Domestically, the government's plans met with a mixed response. The tax hikes came under fire from the main opposition party, the HDZ. Former economy minister, Djuro Popijac, claimed that the tax changes would endanger the country's fragile economic recovery. "I don't know of any example in the world where tax increases have boosted competitiveness. They will worsen conditions for companies and weaken the competitiveness of the economy." His colleague, former prime minister Jadranka Kosor, also weighed in, claiming that the planned budgetary revenues were overestimated by HRK1.5bn, while expenses were underestimated by as much. As a result, she said that the government would soon be forced to revise its financing plans. "It's already obvious that the budget will last only three months and then become history," she said.
HUP, the Croatian employers association, bemoaned the increase in the rate of VAT and the imposition of a new tax on dividend payments, which it said would significantly increase costs for companies and disrupt their business plans. "The HUP can only reiterate once again that we need more radical cuts, implementation of reforms that have been delayed for a long time, and even more significant tax benefits and assistance to the economy. Without that, despite the good course of government measures, the crisis cannot be overcome and there can be no economic growth."
It also said that while the reduction in state spending was a step in the right direction, it fell short of its expectations. "We are surprised by the fact that despite announcements that state spending would be reduced by close to HRK5bn... the final budget proposal envisages a much more modest reduction of HRK3.6bn," the HUP said in a statement, adding that the smaller-than-expected spending cuts would be greeted as bad news by the credit rating agencies and financial markets.
Indeed they were. On February 15, Fitch Ratings said the new Croatian government's proposed fiscal and structural reforms presented a mixed picture. "The Croatian government's proposed HRK3.4bn of expenditure cuts, announced in this week's 2012 budget, is encouraging given the need for fiscal consolidation… However, the planned cuts are less than the HRK4.6bn outlined by the government in late January, and risk being seen as diluted as a result," it said.
Fitch rates Croatia 'BBB-' with a negative outlook, and said it expects to conclude its review of the rating by the end of the first quarter.
Fitch also pointed out that the government's GDP growth forecast of 0.8% in 2012 is optimistic – it assumes a contraction of 1% in 2012. Given the uncertain growth prospects in Croatia, there is widespread scepticism whether the government's proposed spending cuts go far enough.
In its most recent review of the Croatian economy, the International Monetary Fund in February warned the country could once again lapse into recession as a result of the weak economic outlook for the Eurozone, the main destination for Croatia's exports. According to the IMF, economic growth could shrink by as much as 1% this year, following an estimated 0.25% increase in 2011. "Croatia faces considerable economic challenges. Growth prospects are weak due to deep-rooted structural rigidities and competitiveness problems. Meanwhile, vulnerabilities are significant, with high external indebtedness and unsustainable public debt dynamics in the absence of fundamental policy changes. Strong linkages to the euro area imply that Croatia is highly susceptible to spillovers from the euro area crisis. The immediate policy priorities should include launching a credible medium-term fiscal consolidation to retain market confidence and restore debt sustainability," it said.
With external debt having exceeded 100% of GDP, the IMF said that without corrective action the government's budget deficit would remain at around 6% of GDP, pushing public sector debt towards 70% of GDP over the medium term.