Summary: KEY ISSUES Reviving Growth. Croatia remains stuck in an unusually drawn out recession, with real GDP contracting for the 5th consecutive year in 2013. Domestic demand is depressed as corporations and households struggle with excessive debts accumulated in the 2000s. Exports and FDI are also weak, reflecting poor trading partner growth and structural weaknesses. With traditional fiscal and monetary policy responses out of reach (see below), private sector debt restructuring and measures to attract FDI provide the best prospect to revive growth in the short to medium term. Further, labor market reforms are critical to strengthen the economy’s capacity to adapt to external conditions. Restoring Fiscal Sustainability. High fiscal deficits, rapidly increasing public debt and elevated risk spreads demand sustained fiscal consolidation. Adjustment should be stretched over several years, with an emphasis on low multiplier measures—including on the revenue side–during the early phase of consolidation. Safeguarding Monetary and Financial Stability. Monetary policy aims at stability of the kuna-euro exchange, to prevent that a depreciation trigger a contractionary revaluation of FX-indexed debts. The central bank has defended the arrangement with limited but effective instruments, notably FX liquidity and required reserves regulation. The banking system has remained stable in spite of the protracted recession, owing in large measure to the central bank’s aggressive capitalization policy. Previous Staff Advice. Since the 2012 Article IV consultation, the authorities have made progress with reforms to strengthen the legal and regulatory framework for investments and to enhance the labor market’s adaptive capacity. Fiscal policy slipped in 2013, but a renewed effort at consolidation has been made recently with a revised 2014 budget. The 2014 effort remains to be integrated into a coherent, multi-year strategy.

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