CROATIAN ECONOMY BACKED INTO A CORNER

UNCLAS SECTION 01 OF 02 ZAGREB 000061

SENSITIVE
SIPDIS

DEPARTMENT FOR EUR/ERA, EUR/SCE, AND EEB/IFD; TREASURY FOR
INTERNATIONAL AFFAIRS LARRY NORTON

E.O. 12958: N/A
TAGS: ECON EFIN HR
SUBJECT: CROATIAN ECONOMY BACKED INTO A CORNER


1. (SBU) SUMMARY. The Economics Institute of Zagreb (EIZ),
a key independent government think tank, has released a
negative 1.4 percent growth forecast for 2009, the first
domestic institution to forecast negative growth for the
country. Press were quick to publish headlines of recession,
leading to greater anticipation of a package of
anti-recession measures the Prime Minister ordered from his
economic council (of which the director of EIZ is a key
member). At lunch with econoffs on January 29, the EIZ
director privately told us there are few recommendations the
council can usefully make that the government could
undertake. There are no budgetary resources available to
stimulate the economy, new credit will be very hard to come
by, and the central bank cannot afford to let the exchange
rate fall. We asked her whether the government could
continue to avoid the prospect of IMF financing, at least
until after the local elections in May. While she didn't say
IMF intervention was inevitable, she replied that government
finances and debt obligations could easily reach a crisis
point well before the elections. In a meeting with foreign
ambassadors last week, the Vice Governor of the central bank
was more confident the government's financial obligations
were manageable, at least for the first half of the year.
END SUMMARY.

GOVERNMENT LOOKING TO ECONOMIC COUNCIL TO SAVE THE DAY
--------------


2. (SBU) The government has called on its recently-convened
economic experts' council (of which the EIZ director is a
leading member) to provide anti-recession recommendations
this week. Privately, EIZ told us there is no traditional
anti-recession measure, either fiscal or monetary, that the
government will be able to undertake. New stimulative
spending is not an option with the budget in its current
form, but meaningful revision of the budget will be extremely
difficult in the current political environment. New credit
will be very hard to come by given the high stock of foreign
debt. The kuna has to remain relatively stable to avoid
severe pain from the high number of euro-denominated loans
outstanding. She expressed frustration with the task given
to the council and the fact that the government and press are
now looking to them to provide a magic bullet. Instead, she
said the Institute plans to offer suggestions aimed at simply
shoring up economic stability.

BUDGET MUST BE REVISED
--------------


3. The budget agreement hashed out between the government
and unions in December has already proven to be unrealistic.
Revenues in January are already sharply down, and a Finance
Ministry State Secretary publicly admitted earlier this week
that growth figures lower than the budget's 2 percent
forecast were likely, and would soon require a new budget.
The opposition SDP presented their own anti-recession package
late last week including a new bill calling for a civil
servant wage freeze. A similar proposal by the HDZ
government in December to abandon a 6 percent wage increase
called for in the collective bargaining agreement went down
to defeat after strong union opposition. The government's
latest deficit financing plan calls for a large 750 million
euro syndicated loan to be secured in the middle of the year.
According to the EIZ director, tight foreign credit and a
rising risk premium could make the rate on such a loan
difficult to swallow, if such financing would be available at
all.

CONTINUING DEBT SERVICE CONCERNS
--------------


4. The Vice Governor of the Croatian National Bank (HNB)
recently told a group of foreign ambassadors that Croatia's
debt obligations are manageable, at least for the next six
months. The HNB recently lowered its reserve requirement in
order to free up 800 million euro for the government to
borrow from domestic banks to cover a large portion of its
foreign debt service obligations (total obligations for 2009
in the government sector are estimated at 1.23 billion euro).
Private sector foreign debt continues to rise faster than
the government sector and could pose an even greater
challenge to the economy. The stock of private sector debt
rose last year 15 percent to over 27 billion euro. Debt
servicing obligations for the private sector in 2009 are
estimated at over 8 billion euro. Many banks and companies
have told the EIZ privately that they have individual
strategies they are confident will help them weather the
crisis, but none have been willing to reveal exactly what

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those strategies may be. According to EIZ, exchange rate
pressure alone has been responsible for a 10 percent
deterioration in the debt/GDP ratio, which now stands at
nearly 100 percent.

THE CENTRAL BANK HAS LITTLE FLEXIBILITY WITH THE KUNA
--------------


5. A managed currency depreciation to spur the export sector
and improve Croatia's trade balance is not an option for the
HNB, according to the EIZ director. With a large proportion
of private sector loans denominated in euros, and currency
clauses in most loans that pass exchange rate losses on to
the consumer, a depreciation of the kuna would be too painful
for the economcy to bear. A depreciation might also be of
little utility in rebalancing trade, since many of Croatia's
highest value manufactured exports, such as shipbuilding, are
composed mainly of inputs imported from abroad. The kuna is
sliding against the euro, but the HNB is determined to do
what it can, recently expending 328 million euro of its
foreign currency reserves to halt the slide (this in
comparison to 1 billion in reserves it spent for this purpose
during all of last year).

A FEW BRIGHT SPOTS
--------------


6. The EBRD, which holds the largest development lending
portfolio in Croatia, recently praised Croatia's overall
reform path, and said the economy was still well positioned
for long term growth (despite the EBRD's own zero percent
growth forecast). The EBRD also announced it will make as
much as 300 million euro in new credit available, targeting
small and medium enterprises. HNB's stock of foreign
reserves remains significant, around 9 billion euro (although
further pressure on the kuna this spring could certainly
deteriorate their position). The banking sector remains
stable by all accounts. The banks are well capitalized,
deposits are strong, and domestic credit is still available
(although rates are rising).


7. COMMENT: The qualified optimism of the central bank and
the EBRD on debt servicing and long-term growth prospects
suggest Croatia is better positioned than many to avoid
long-term damage from the crisis. But in the short term,
there are few good options for the economy, and little or no
margin for error. We can expect some attempt at a budget
revision soon. We still believe the government will do all
it can to avoid the IMF, at least until after May's local
elections, but it was sobering to hear the view of one of
Croatia's more influential economists at the EIZ that things
could spin out of control well before then. She also told
us, though, that negative 1.4 percent growth could easily
turn out to be much better than the recessions faced by other
countries in the region. That's what passes for good news
these days in Croatia. END COMMENT.
BRADTKE