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2003-11-20 06:27:00
Embassy Zagreb
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						C O N F I D E N T I A L  ZAGREB 002446 


E.O. 12958: DECL: 11/19/2008

Classified By: Economic Officer Isabella Detwiler reasons 1.5 (b and d)


C O N F I D E N T I A L ZAGREB 002446


E.O. 12958: DECL: 11/19/2008

Classified By: Economic Officer Isabella Detwiler reasons 1.5 (b and d)


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

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

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

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.