US embassy cable - 03ZAGREB2666

C O N F I D E N T I A L  ZAGREB 002666 
 
SIPDIS 
 
 
E.O. 12958: DECL: 12/22/2013 
TAGS: ECON, EFIN, PGOV, HR, Trade 
SUBJECT: IMF CONCERNED THAT DEFICITS WILL RISE UNDER NEW 
GOVERNMENT 
 
REF: ZAGREB 2446 
 
Classified By: ECONOMIC OFFICER ISABELLA DETWILER: REASON 1.5 (B AND D) 
 
Summary 
------- 
 
1.  (C) The incoming government is playing its economic game 
close to its chest.  A visiting IMF team that met informally 
with the HDZ's economic players came away without much new 
information.  The HDZ's campaign promises, much like the 
campaign promises of the other parties, were expensive. 
Perhaps more worrying, because they were in writing, were the 
concessions the HDZ made to the Pensioners Party (HSU) in 
order to secure its three votes in the next Parliament.  If 
implemented in anything like their current form, concessions 
would severely boost the budget deficit and upset the 
delicate balance the last government reached on pensions. 
 
2.  (C) In what was not a big surprise given the timing of 
the team's visit -- right after parliamentary elections -- 
the IMF was not able to complete the third review of the 
Stand-by Arrangement.  It was in no position to judge 
Croatia's economic plans for the next 12 months -- primarily 
because the plans do not really exist yet.  The IMF, the 
outgoing government, and Central Bank were able to complete 
an informal, backward-looking review, which found the 
situation generally satisfactory, but with some lingering 
areas of concern.  End Summary. 
 
Expensive Promises 
------------------ 
 
3.  (C)  The two areas of the HDZ's economic policies that 
have attracted the most attention appear to have come from 
two different camps within the HDZ.  A cut of two percent in 
the VAT tax was urged by young academic (and former Central 
Bank employee) Ante Babic.  Babic, who is rumored to be 
interested only in an advisory role in the new government, is 
said to believe that this tax cut would stimulate business, 
rather than translate into lower prices.  However, a recent 
roundtable of business people reportedly scoffed at the idea, 
and worried about the fiscal effects.  The VAT cut, estimated 
to cost about 1.2 percent of GDP, would be partially financed 
by increased compliance and enforcement of tax collections, 
optimistically estimated to provide additional revenue of 0.4 
percent of GDP. 
 
Pensioners Strike Back? 
----------------------- 
 
4.  (C)  In an unpublished but well-reported memorandum 
signed by representatives of the HDZ and the HSU, it was 
agreed to increase the base level of pensions and adopt a 
more favorable methodology for indexation. Other goodies are 
rumored, but not confirmed.  World Bank economists have 
estimated that if the additional costs were fully covered by 
additional payroll taxes (not likely), the contribution rate 
would rise from 20 percent to 35 percent.  Even if the 
worst-case scenario does not materialize, any significant 
increase in payroll taxes would create additional 
disincentives to employment.  The World Bank and others also 
worry that these changes will destroy what have been the 
significant accomplishments of the Racan government's 
three-pillar pension reform.  One possible result is that the 
private sector second and third pillars would be "crowded 
out" by the bulking up of the first, pay-as-you-go, pillar. 
 
5.  (C)  The IFIs have tried, in the absence of hard plans or 
data from the incoming government, to calculate the effect of 
these proposals on the fiscal deficit.  The deficit, which 
was expected to be 4.5 percent of GDP in 2003 and drop to 3.8 
percent next year, could increase to between 5.8 and 8 
percent, depending on assumptions.  The calculation that 
arrives at the lower (but still large) figure increases the 
deficit for the VAT reduction, promised wage increases, 
pension and maternity benefit increases, investments in the 
railroads (also promised by the SDP, to have been paid for by 
social transfer cuts), and decreases the deficit through the 
hoped-for better collection of taxes and a fairly generous 
credit for capital expenditure cuts to the tune of 0.7 
percent of GDP.  While many do not believe that the HDZ will 
be able to implement this full package, if a significant 
fraction of it is, the budget deficit could balloon. 
 
IFIs in Limbo 
------------- 
 
6.  (C)  The IMF team visiting Zagreb in December left after 
signing what was called a letter of intent.  It looked more 
like a memorandum looking back over developments over the 
last few months.  Several players in the process told us that 
 
 
it was not quite clear why the IMF was here.  The GOC's 
principle interlocutor with the IMF reportedly opposed the 
team's coming, while the Central Bank said that, if the team 
came, it had to complete the review.  As it is, the letter 
signed by the three parties concludes "...we believe that our 
program implementation during 2003 has been broadly 
satisfactory, and it is our sincere hope that the third 
review can be completed early next year."  The IMF has 
tentative plans to come back in late February (the program 
lapses in early April), at which time the next government 
would have to be ready to present detailed plans and a budget. 
 
7.  (C)  When the new IMF Mission Director for Croatia, 
Dimitri Demekas, met with us, he said he had told the HDZ 
leadership -- including Prime Minister-designate Sanader and 
top economic advisor (and incoming Finance Minister) Ivan 
Suker -- to take their time in deciding what form of 
cooperation they would like to have with the IMF.  Demekas 
emphasized to us that he was not pushing another Standby 
Arrangement on the incoming government (a good thing, since 
the HDZ has publicly expressed its skepticism about such a 
program).  The IMF would like to keep engaged, however, 
perhaps through intensive monitoring, and would like to keep 
an office in Zagreb.  According to Demekas, the HDZ officials 
were polite and non-committal. 
 
8.  (C)  The World Bank's Country Director also told the 
Ambassador that the World Bank would like to see a strong IMF 
presence in Croatia.  He quipped that while they were 
flattered by HDZ statements that they wanted to "graduate" 
from IMF programs and that they would prefer to work more 
closely with the World Bank, the IMF and World Bank came 
together.  We have received mixed information on whether an 
IMF program would be necessary for the next big World Bank 
program, and Programmatic Adjustment Loan. 
 
Racan Government takes a Bow 
---------------------------- 
 
9.  (C)  As reported reftel, the Racan government leaves 
office with higher than expected growth -- projected at 5 
percent this year -- and lower than expected inflation.  The 
accumulated government debt has stabilized at 51 percent of 
GDP, the fiscal deficit will come in better than programmed, 
at 4.5 percent of GDP, and even the current account deficit 
is better than feared, at 5.4 percent of GDP.  The dark 
cloud, especially given the Standby Arrangement's focus on 
stabilizing overall debt, is the burgeoning foreign debt -- 
public and private -- which increased from 68.5 percent of 
GDP to an expected 74 percent in the past 12 months, spurred 
on also by booming consumer borrowing.  The IMF remains 
unhappy with the Central Bank's monetary instruments, and the 
government and Central Bank point fingers at each other 
assigning  blame. 
 
Comment 
------- 
 
10.   (C) The new HDZ-led coalition will have its hands full 
on the economic front, and the fact that it will effectively 
be a minority government will make matters all the more 
tenuous.  Because HDZ made a lot of generous promises during 
the election campaign to cut taxes -- and now must give away 
much to get small coalition partners on board -- it will be 
difficult for the new economic team to start preaching fiscal 
rectitude.  But sooner or later it likely must, and at that 
time it may appreciate having the IMF, in some form, around 
to serve as the bogey man requiring it to do a course 
correction. 
FRANK 
 
 
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