THE ECONOMY -- SANADER GOVERNMENT'S ACHILLES HEEL?

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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