US embassy cable - 03ZAGREB2446

C O N F I D E N T I A L  ZAGREB 002446 
 
SIPDIS 
 
 
E.O. 12958: DECL: 11/19/2008 
TAGS: ECON, EFIN, PGOV, HR, Political Parties/Elections 
SUBJECT: CROATIAN VOTERS RELUCTANT TO GIVE CREDIT FOR 
GROWTH TO CURRENT GOVERNMENT 
 
Classified By: Economic Officer Isabella Detwiler reasons 1.5 (b and d) 
 
Summary 
-------- 
 
1.  (SBU) Going into the elections this weekend, the current 
coalition government has a good story to tell -- healthy GDP 
growth, declining unemployment, progress on its Stabilization 
and Association Agreement with the EU, new roads, and 
constructive relationships with the IMF and World Bank.  Even 
on the structural side, the government has made some major 
advances, such as in pension reform and downsizing of the 
police and military.  The main clouds on the horizon are 
burgeoning debt, both private and public.  Whether the 
progress was great enough and fast enough for the voters to 
give the government credit is in doubt.  Additionally, the 
Croatian public appears to share a characteristic with other 
central and eastern Europeans -- they perceive their 
situation to be significantly worse than the numbers would 
indicate.  End Summary 
 
Perils of Pauline with the IFIs 
------------------------------- 
 
2.  (C) On November 12, the IMF completed a second review of 
its Stand-by Arrangement with Croatia.  While Croatia needed 
four waivers -- in part because the national oil company 
privatization receipts came in after the formal end of the 
review -- the IMF had a hard time arguing with 
greater-than-planned GDP growth (for the second year in a 
row), budgetary restraint, and strong foreign reserves.  Many 
observers had anticipated a train wreck on the current 
account deficit -- this year's big issue -- but, if the 
figures are to be believed, an enormously successful tourist 
season saved the Croatian government at the last hour.  (This 
is reminiscent of the situation last year, when the fiscal 
deficit was the major concern.  The government ended up 
confounding the IMF and most observers by outperforming that 
target as well by an almost inexplicable under-execution of 
the budget.) 
 
3.  (SBU) Another rabbit-out-of a-hat moment came when the 
government managed to pass a package of laws and amendments 
to fulfill conditions for the second tranche of its World 
Bank Structural Adjustment Loan.  The World Bank showed 
repeated flexibility, including delaying the "drop-dead" 
deadline of the review.  This approach paid off, since the 
government secured reforms to the labor laws considered 
impossible by many -- albeit while alienating its allies in 
the labor unions in the process.  The parliament also passed 
legislation on bankruptcy, budget preparation, corporate 
governance and competition.  Between these achievements and 
the laws the government has scrambled to pass to fulfill 
requirements of the EU, Croatia has made great progress on 
its legislative framework.  Implementation and enforcement 
will continue to be sticking points. 
 
Despite Everything, Quite a bit of Success 
------------------------------------------ 
 
4.  (C) This phenomenon -- outperforming economically almost 
despite itself -- has been characteristic of this government. 
 Despite a woeful lack of economic talent, especially at the 
Ministries of Finance and Economy, the economy is on an 
upward, if shaky, path.  Much of the credit goes to prudent 
management at the Central Bank and lack of alternative 
investment opportunities in Western Europe, but also the 
prudent decisions of the previous and current governments to 
privatize the banking sector, most of the national 
telecommunications company, and a large chunk of the oil 
company, as well as the decision of this government to pursue 
restrictive agreements with the IMF and World Bank.  The 
efforts of numerous small and medium-sized entrepreneurs, 
while hard to quantify, appear to be playing an increasingly 
important part in the economic recovery. 
 
5.  (SBU) The banking crisis of the late Tudjman regime and 
the resultant recession forced the Socialist (SDP)-led 
government to move ahead on reforms that it might otherwise 
have avoided.  Whatever the motivation, the government can 
point to the strongest GDP growth in the region -- 5.2 
percent last year, 3.8 percent in 2001, and 3.9 percent in 
the first year of its mandate, 2000.  Projections for this 
year range from a low of 3.5 percent up to five percent -- 
with the final result likely to be closer to the higher 
number.  Inflation has been lower even than expected, less 
than two percent this year, and 2.2 percent last year. 
Foreign Direct Investment has fluctuated with several large 
deals, but, despite being well below potential, it has put 
Croatia in the middle of the Central and Eastern European 
pack in per capita terms.  The fiscal deficit remains too 
high, but decreased from 6.5 and 6.8 percent of GDP in 2000 
 
 
and 2001 respectively, to 4.8 percent in 2002 and is expected 
to come in close to the planned 4.6 percent this year.  The 
government has ambitious plans to cut the deficit to 3.8 
percent in 2004 -- a goal they have perhaps wisely not made 
public. 
 
6.  (U) Unemployment, in many ways the bottom line, has begun 
to move downwards.  After reaching a high of 16.1 percent in 
2000 (ILO-survey), it fell to 14.1 for the first half of this 
year -- still above the 13.6 percent of the HDZ's final year. 
 
7.  (SBU) Of course, this rapid growth has been accompanied 
by some economic imbalances, which if not addressed, could 
lead to or worsen the next recession.  Much of this 
impressive growth was fueled by government investment, 
principally in roads, and frantic consumer (and business) 
spending.  While industrial production has been increasing 
steadily, much of this spending is on imports.  This led to 
an eye-popping increase in the current account deficit, from 
3.7 percent of GDP in 2001 to 7.2 in 2003.  While the IMF had 
hoped to drive this down to 3.6 in the current year, it had 
to adjust its goal to 5.9 after the first review of the 
Standby Arrangement, and even then feared the goal would be 
missed. 
 
8.  (C) In a suspiciously dramatic escape, as-yet unpublished 
data showed that tourism inflows for the first nine months of 
this year were 89 percent (yes, eighty nine) above last year, 
thus allowing the GOC to make the revised current account 
deficit goal.  While the IMF is understandably skeptical, it 
has not been able to poke holes in the numbers.  The local 
IMF rep told us that the best indication that the data, if 
not actually accurate, at least are not an out-and-out lie, 
is that the Central Bank also refused to believe the numbers 
at first, until it found it could not refute them. 
 
Curbing Credit Growth 
--------------------- 
 
9.  (SBU) Perhaps more sustainably, measures that the Central 
Bank took to slow down the growth of credit and debt have 
begun to take hold.  The annual rate of credit expansion fell 
from 31.3 percent at the end of 2002 to below 20 percent, and 
is still falling, much to the distress of the banks and 
businesses. 
 
10.  (C) Debt has become the latest target of concern among 
the financial press and critics of the government, including 
the Central Bank.  Total external debt, both public and 
private has soared from 59.7 percent of GDP in 2000 to 68.5 
percent in 2002.  The Central Bank, resisting efforts from 
the IMF to tighten monetary policy further for fear of being 
blamed for a recession, has argued that government spending 
and guarantees to public companies are the main culprits of 
the expanding debt -- an argument that may be overblown. 
Public debt increased more moderately from 51.1 percent of 
GDP in 2000 to 51.6 in 2002.  Given the size of the current 
account deficit, the IMF and others want to squeeze both the 
increase in imports by slowing credit growth (through 
monetary policy) and government spending.  The government is 
also being pushed to finance more of its needs on the 
domestic market.  A properly functioning Ministry of Finance 
would certainly help in this area. 
 
11.  (C) While the official numbers for public debt do not 
look overly alarming, the GOC did breach its agreement with 
the IMF not to issue more guarantees than it retired.  Most 
of the new guarantees were for a railroad improvement 
project, which in its current, ambitious form, is met with 
skepticism by both the World Bank and the IMF.  The 
government plans to pay for future hefty investments in 
railroads with cuts in other spending, including social 
transfers and subsidies. 
 
Privatization Mixed 
------------------- 
 
12.  (SBU) On privatization, the picture is also mixed.  The 
state telecommunications company is majority-private, due to 
a process started by the previous government.  The current 
government pushed though a very successful sale of 25 percent 
plus one share of the state oil company, with a further 15 
percent to be privatized next year.  As mentioned earlier, 
the banking sector is largely in foreign, private hands.  The 
government is scaling back and pushing back the sale of parts 
of the state electricity company, specifying that now only 
distribution will be privatized.  The sale of the state 
insurance company can be considered a failure, as the GOC 
negotiates with the Catholic Church to take 25 percent of the 
company as compensation for post-WWII expropriations, and 
proposes the sale of an additional 20 percent through the 
stock exchange.  However, private insurance companies 
 
 
continue to expand their market share. 
 
13.  (C) The Croatian Privatization Fund handles the large 
state portfolio of smaller properties, mainly tourist and 
industrial properties.  After a politically motivated 
brouhaha over the sale of a resort complex on the island of 
Hvar early this year, no sales of companies have been 
finalized.  However, tender preparations continue, 35 
entities were tendered, and contracts are being negotiated 
for 12 of these.  Also in the past year, the government 
divested itself of minority shares in various companies 
valued at approximately $40 million.  While both the right 
and the left are shying away from discussing privatization 
during the campaign, both the right-of-center HDZ and 
left-of-center SDP seem to recognize the necessity of 
off-loading money losing enterprises.  However, the Croatian 
Peasant's Party, which brought the current privatization 
process to a near halt and whose support is very likely 
needed to form the next coalition, takes the most stridently 
anti-privatization line and could continue to play an 
obstructionist role in the next government. 
 
No Respect 
---------- 
 
14.  (SBU) Despite the government's significant successes, 
and despite porky "goodies" such as roads and subsidies to 
struggling industries, most notably in the shipbuilding and 
ship repair industries, the public appears unappreciative. 
While rates of poverty are relatively low -- 5 to 10 percent 
depending on the measure, in line with Slovenia and the Czech 
Republic -- over half the public, according to one poll, say 
they are barely making ends meet and need to take out loans. 
Another poll shows that, despite evidence to the contrary, 58 
percent of respondents thought that unemployment was 
increasing.  32 percent thought economic growth was negative, 
and 37 percent thought it was unchanged.  A dismal 51 percent 
thought their living standards had deteriorated since the 
ruling coalition came to power, only 14 percent thought 
living standards had improved. 
 
15.  (C) While this exaggerated pessimism appears to be a 
characteristic of the region, it may be magnified in Croatia 
because of the fractious nature of the coalition, the 
legacies of the war, and discrepancies in growth between 
Zagreb and the coast on one hand, and the rest of the country 
on the other.  It is a distinct possibility that this 
pessimism will translate into a vote against the current 
government, in order to punish it for sins real and imagined. 
FRANK 
 
 
NNNN