US embassy cable - 04ZAGREB627

C O N F I D E N T I A L  ZAGREB 000627 
 
SIPDIS 
 
 
E.O. 12958: DECL: 04/08/2013 
TAGS: ECON, EFIN, PREL, HR, Trade 
SUBJECT: THE ECONOMY -- SANADER GOVERNMENT'S ACHILLES HEEL? 
 
Classified By: Economic Officer Isabella Detwiler: Reason: 1.5 (B AND D 
) 
 
Summary 
------- 
 
1.  (C) While the Sanader government has scored points on the 
foreign policy and political fronts, it is faltering on the 
economic front.  The government inherited certain economic 
weaknesses, further handicapped itself with slavish campaign 
promises, then shot itself in the foot with weak appointments 
to economic positions.  While the government has been forced 
to recognize that it needs an IMF program, it does not appear 
to have a strategy on how to make the painful changes 
necessary for a new Standby Arrangement.  Despite the 
grumbling of economists and citizens, the markets remain 
unfazed.  End Summary. 
 
Good news/Bad news: Economy Cooling 
----------------------------------- 
 
2.  (C) While the IMF and the previous government maintained 
until late into the year an estimate for 2003 GDP growth of 5 
percent, no one was too surprised when it turned out to be 
4.4 percent.  The incoming government's official and 
conservative estimate for 2004 of 3.2-3.4 percent also 
reflects the consensus that the economy is cooling.  That 
should be good for the current account deficit and mounting 
foreign debt, but as the government's macroeconomist in the 
Ministry of Finance conceded, growth in this range is not 
enough to continue to pull down the unemployment rate.  And 
there is no guarantee that the economy will not slow down too 
fast or too far.  (On a positive note, unemployment has 
continued to fall, and despite claims to the contrary, the 
number of registered unemployed was 10 percent lower in 
February 2004 than a year earlier. 
 
3.  (C) The lower-than-projected growth was not the only bad 
news at the end of year.  For reasons that remain murky, the 
budget was blown in the last few months of the year, mainly 
after the election, but before the new government took over. 
Some "overspending" was due to the current government's push 
to classify as much spending as 2003 spending as possible in 
areas where there was accounting leeway.  Other overspending 
was due to good weather, which allowed the acceleration of 
road construction.  It also appears that the government 
accelerated the payment of some bills.  The net effect was 
that the final deficit came in a full percentage of GDP over 
the target of 4.5 percent. 
 
4.  (C) Paradoxically, the ratio of government debt to GDP 
has stabilized at about 52 percent, while the foreign debt 
(combined public and private) has continued to soar -- 76 
percent of GDP at the end of 2003, and climbing.  While, as 
the Central Bank governor pointed out last year, some of this 
"private" sector borrowing may actually be state-owned 
companies, much of the new debt is a result of local 
subsidiaries of foreign-owned banks bringing in funds to fuel 
a consumption-led boom.  Administrative measures by the 
Central Bank last year to slow the growth in credit by using 
reserve requirements to penalize banks that lent too much 
appear to have been widely circumvented.  "Loans" became 
"leases" and larger corporate borrowers simply borrowed 
directly from abroad. 
 
5.  (SBU) The current account deficit is showing some signs 
of improvement, but not as rapidly as everyone would like. 
The figure for 2003 is a scary sounding 7.2 percent, but 
reportedly includes a large (1.1 percent of GDP) one-off 
accounting entry, which the Central Bank argues means the 
"real" deficit was "only" 6.2 percent, just a bit over the 
target of 6.0 percent, and much lower than the 8.5 percent of 
2002.  However, the trade deficit continues to increase, and 
the economy remains dangerously dependent on strong tourist 
seasons to lower the current account deficit. 
 
6.  (C) The Central Bank has been talking up the need for the 
government to use fiscal policy to rein in demand, claiming 
that as an open, euro-ized economy, monetary policy would be 
ineffective in Croatia.  Nevertheless, the Central Bank has 
been working with the IMF on a package that would combine an 
increase in interest rates with tools to prevent excessive 
inflows of capital. 
 
The SBA is Dead; Long live the SBA 
---------------------------------- 
 
7.  (C) It became clear early this year that the current 
precautionary Standby Arrangement with the IMF was dead, with 
most of its targets blown by larger or smaller margins.  But 
with a new government in power, newly convinced (by the EU) 
of the wisdom of maintaining and negotiating a new SBA with 
 
the Fund, the IMF found it hard to "punish" anyone.  The 
early-March announcement that the SBA was off-track, 
carefully orchestrated by the government and the IMF to 
minimize "panic," was greeted by a collective yawn by 
international markets. 
 
8.  (C) While PM Sanader has decreed that there will be a new 
Standby Arrangement, it is unclear whether he is willing to 
make the sacrifices to reach one.  Negotiations on a new SBA 
should begin the second half of April, with a Board meeting 
in the late summer.  While the IMF appealed to the government 
during the visit of the country director in February not to 
make fiscal decisions that would hem the government in, the 
government has forged ahead with a relatively loose budget, 
delivering partially on expensive pension promises, and 
moving a step closer to an expensive tax cut. 
 
9.  (C) Part of the government's determination to attribute 
as much spending as possible to the previous government was 
to establish a high base from which to "decrease" government 
spending.  To a certain degree, this has worked.  Before the 
budget was passed in early March, the IMF told us that it 
would not support a spending level of 4.5 percent for 2004, 
since the previous SBA had targeted a deficit of only 3.8 
percent.  At this point, the IMF appears to have given up on 
further cuts this year, but is aiming for an ambitious 3.7 
percent in 2005. 
 
One-Two Punch to the Budget 
--------------------------- 
 
10.  (C) Despite the government's professed right-of-center 
orientation, the military and police arguably got short 
shrift in the budget process.  Social spending was the most 
lavish, as the government delivered on promises it made to 
the pensioners' party to secure the support of its three 
seats in the Parliament.  Health and road construction were 
also winners, while increased spending on railroads was 
delayed for at least one year (although there are rumblings 
that some spending may be restarted). 
 
11.  (C) The most distressing development, because of its 
long-term impact and the political difficulty of reversing 
it, is the set of changes made to the pension insurance law 
in March.  The legislation formalized a change in the 
indexation of pensions from a price-wage index to an index 
based solely on nominal wage increases, as well as an 
increase to the base pension.  The tax exemption for 
pensioners was also increased.  These changes alone will 
increase government spending on pensions by 23 billion kuna 
(about $3.8 billion) over ten years, by GOC estimates.  It 
would reverse the previous downward trend in spending on 
pensions as a percent of GDP, increasing spending by almost 
two percent of GDP by 2013.  And this is only part of the 
package promised by Sanader. 
 
12.  (C) The government has promised to submit to Parliament 
by June a package further sweetening the pensions. 
Indexation would be raised again, to a combined index using 
wage and nominal GDP increases, plus a payment of the 
so-called "pensioners debt," which the past government had 
successfully (at least legally) settled.  The stated aim of 
the package is to bring the average pension to 70 percent of 
the average wage.  This would be incredibly generous by 
almost any standard and would gut the recent pension reform, 
which sought to shift people from a failing "pay-as-you-go" 
system to individualized retirement accounts. 
 
13.  (C) The problem is particularly acute because of the 
large number of people on pensions -- an incredible 1.1 
million out of a population of 4.4 million and a workforce of 
only 1.7 million.  The average net pension is less than 2000 
kuna, or $350 dollars, which, while not bad by area 
standards, makes arguments that pensions need to be curbed 
politically difficult. 
 
14.  (C) Further complicating the task of lowering the 
deficit and reaching an agreement with the IMF is the VAT 
cut, brainchild of key Sanader advisor Ante Babic.  This will 
cost up to 3 billion kuna.  The cut has surprisingly few 
supporters.  Consumers are skeptical the cut will translate 
into lower prices, economists are skeptical it will stimulate 
business, and even some government officials have indicated 
to us they would have preferred to see a cut in payroll taxes 
to increase competitiveness.  Despite the lack of popular 
support, the parliament took a step in the direction of 
no-return when it passed a law April 2 that committed the 
government to lower the VAT rate from 22 to 20 percent 
beginning January 2005.  So far, efforts to collect 
additional revenues from administrative reform and improved 
tax collection -- identified by Babic as sources to make up 
the shortfall -- appear not to have even gotten off the 
 
drawing board. 
 
Shallow Talent Pool 
------------------- 
 
15.  (C) The economic team -- if it can be called that -- 
does not seem to be functioning.  As far as we can tell, 
there is little coordination.  Deputy Prime Minister in 
charge of the economic portfolio, Dr. Andrija Hebrang, does 
not have a background in either economics or in business.  He 
is embroiled in almost daily battles with the media and the 
medical establishment on issues arising from his "other job," 
as Minister of Health.  Ante Babic, State Secretary in the 
Prime Minister's office for Strategic Development, and 
self-described "mastermind" of the Sanader government's 
economic policy, appears to be increasingly side-tracked. 
After authoring the VAT reduction, the idea to enforce 
central procurement of local input for state-owned shipyards, 
and failing to prevent the giveaway to pensioners, that may 
be just as well.  Finance Minister Suker at least has budget 
hawk instincts, but as a small town mayor and tax collector, 
may not have the inclination or ability to form broader 
economic policy. 
 
16.  (C) Thus the responsibility has had to flow up, to 
Sanader, and down, to State Secretary of the Ministry of 
Finance, Martina Dalic.  Dalic headed the macroeconomist 
department of the Ministry in the previous government, then 
left to become the chief economist at the Croatian branch of 
Raiffheisen Bank.  She is well-respected and has shown 
formidable determination and vigor in trying to whip the 
dysfunctional Ministry of Finance into shape.  However, in 
addition to her other duties, she is now effectively in 
charge of both IMF and World Bank negotiations (Babic having 
been sidelined from the latter).  It is doubtful that she has 
the political weight to demand concessions from Ministers. 
Thus, important decisions will have to be backed by her 
Minister, and in most cases, the Prime Minister. 
 
17.  (C) Meanwhile, Minister of Foreign Affairs Zuzul has 
done more to promote Croatian exports and investment in 
Croatia than the "invisible" Minister of Economy Branko 
Vukelic.  The problems in the Ministry of Economy extend 
downward -- key positions have been filled with weak 
candidates, and experienced staff let go.  A strong Minister 
of Transport and Infrastructure, Bozidar Kalmeta, will 
probably be good for Croatia's infrastructure development, 
but left unchecked, could put even more strains on the 
budget.  Preliminary signals from our EC counterparts 
indicate that the new Minister of EU Integration -- whose 
ministry has some influence on the pace of overall reforms -- 
Kolinda Grabar-Kitarovic, may be having difficulty filling 
the large shoes of her predecessor. 
 
Comment 
------- 
 
18.  (C) Croatia has had a weak economic team for years, yet 
still experienced respectable economic growth.  It is too 
early to say that the good luck has run out.  However, it is 
clear that the bad decisions of the last few months could be 
the seeds of future crisis if left uncorrected.  The IMF will 
play a key role in giving the government cover to reverse 
itself; one question is whether the IMF can or should bend 
enough to reach an agreement with which the Sanader 
government can live, given the HDZ's lack of a majority in 
the parliament.  The World Bank, for now, is insisting that 
the government conclude an SBA with the IMF in order for the 
government to access the goodies of the Programmatic 
Adjustment Loan.  Meanwhile, as the GOC has recently found on 
a bond-selling road trip that the markets continue to smile 
on Croatia, delaying the day of reckoning. 
 
FRANK 
 
 
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