VZCZCXRO3661
RR RUEHAG RUEHDA RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA RUEHLN RUEHLZ
RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHVB #0320/01 0681435
ZNR UUUUU ZZH
R 091435Z MAR 06
FM AMEMBASSY ZAGREB
TO RUEHC/SECSTATE WASHDC 5823
INFO RUEHZL/EUROPEAN POLITICAL COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/DEPT OF COMMERCE WASHDC

UNCLAS SECTION 01 OF 02 ZAGREB 000320 
 
SIPDIS 
 
SIPDIS 
 
SENSITIVE 
 
E.O. 12958: N/A 
TAGS: ECON EFIN HR
SUBJECT: CROATIA'S LIMITED ECONOMIC CHOICES 
 
 
(U) SENSITIVE BUT UNCLASSIFIED; PLEASE HANDLE 
ACCORDINGLY. 
 
¶1.  (SBU) SUMMARY:  ALTHOUGH CROATIA ENJOYS MODEST 
ECONOMIC GROWTH AND LOW INFLATION, TWO SUCCESSIVE 
GOVERNMENTS HAVE DONE LITTLE TO SIGNIFICANTLY BOOST 
ECONOMIC ACTIVITY OVER THE PAST FIVE YEARS. 
PARTIALLY, THIS IS THE RESULT OF POLITICAL INERTIA 
AND AN UNWILLINGNESS TO CONFRONT ENTRENCHED 
INTERESTS, BUT IT IS EQUALLY A CONSEQUENCE OF 
ECONOMIC IMBALANCES FOR WHICH THERE ARE NO READY 
SOLUTIONS.  THE CONFLUENCE OF STUBBORNLY HIGH FISCAL 
DEFICITS, A GROWING TRADE DEFICIT, SOARING FOREIGN 
DEBT, DOUBLE-DIGIT UNEMPLOYMENT AND AN OVER-VALUED 
DOMESTIC CURRENCY SEVERELY CIRCUMSCRIBES THE 
GOVERNMENT'S ABILITY TO USE EITHER FISCAL OR 
MONETARY POLICY TO BOOST CROATIA'S ECONOMIC GROWTH. 
END SUMMARY. 
 
ECONOMIC GROWTH AND PERSISTENT IMBALANCES 
----------------------------------------- 
¶2.  (SBU) CROATIA'S ECONOMY HAS GROWN AT A MODEST 
RATE FOR EACH OF THE PAST SIX YEARS, WITH 
PRELIMINARY FIGURES INDICATING A GDP GROWTH OF 
APPROXIMATELY 4.0 PERCENT IN 2005.  ALTHOUGH 4.0 
PERCENT GROWTH IS CONSIDERED STRONG IN MORE 
DEVELOPED ECONOMIES, IT IS RELATIVELY LACKLUSTER FOR 
A TRANSITION ECONOMY LIKE CROATIA'S AND DOES LITTLE 
TO REPLACE THE LARGE NUMBERS OF JOBS LOST OVER THE 
LAST 15 YEARS AS OLD INDUSTRIES FAILED OR WERE 
RESTRUCTURED.  CONSEQUENTIALLY, CROATIA'S 
UNEMPLOYMENT RATE HAS REMAINED HIGH DESPITE ECONOMIC 
GROWTH, RUNNING AT 18.5 PERCENT IN 2004, ACCORDING 
TO OFFICIAL STATISTICS. (NOTE: THE ILO, WHICH USES A 
DIFFERENT METHODOLOGY TO CALCULATE UNEMPLOYMENT, 
GIVES A RATE OF 13.8 PERCENT FOR THE SAME YEAR.) 
 
¶3.  (SBU) THE CROATIAN GOVERNMENT'S ENTITLEMENT 
BURDEN IS SUBSTANTIAL, MADE WORSE BY A GENERAL LACK 
OF MEANS TESTING FOR BENEFITS AND ENTRENCHED 
INTEREST GROUPS THAT MAKE SERIOUS REFORM POLITICALLY 
DIFFICULT.  BEYOND THE BURDEN OF UNEMPLOYMENT 
BENEFITS, THE GOC SPENDS LARGE SUMS ON PENSIONS, 
HEALTHCARE AND OTHER SOCIAL SPENDING.  ON PENSIONS, 
THE NUMBERS ALONE TELL THE STORY WITH 1 PENSIONER 
FOR EVERY 1.4 PEOPLE EMPLOYED.  AS IN MUCH OF 
EUROPE, DEMOGRAPHICS ARE NOT IN CROATIA'S FAVOR. 
CROATIA CURRENTLY SPENDS OVER 7 PERCENT OF GDP ON 
HEALTHCARE, ABOVE THE EU AVERAGE AND PARTICULARLY 
UNSUSTAINABLE FOR A TRANSITION ECONOMY.  HOWEVER, 
RECENT EFFORTS TO REFORM THE HEALTHCARE SYSTEM AND 
INTRODUCE CO-PAYMENTS FOR CONSUMERS WERE SCALED BACK 
SO THAT AN ESTIMATED SAVINGS OF $300 MILLION 
ANNUALLY WAS REDUCED TO $50 MILLION, LARGELY THROUGH 
THE SUBSTITUTION OF BRAND-NAME DRUGS WITH GENERICS. 
STATE SPENDING EXTENDS WELL BEYOND WELFARE TO 
INDUSTRY, AGRICULTURE, THE NATIONAL RAILROAD, SHIP 
BUILDING AND OTHER INDUSTRIES WITH TOTAL SPENDING 
TOTALING APPROXIMATELY 3 PERCENT OF GDP. ALL TOLD, 
THE STATE'S ROLE IN CROATIA'S ECONOMY IS ESTIMATED 
TO BE OVER 40 PERCENT OF GDP. 
 
CHRONIC BUDGET DEFICITS 
----------------------- 
¶4.  (SBU) WITH SUCH HIGH LEVELS OF PUBLIC SPENDING, 
IT COMES AS LITTLE SURPRISE THAT THE CROATIAN 
GOVERNMENT HAS RUN CHRONIC DEFICITS.  THE IMF HAS A 
STAND-BY ARRANGEMENT IN PLACE WITH CROATIA AND HAS 
SEEN SOME SUCCESS IN REDUCING DEFICITS OVER THE LAST 
FEW YEARS, WITH A 2005 TARGET OF 4.2 PERCENT OF GDP. 
HOWEVER, INTERNATIONAL PRESSURE TO REDUCE SPENDING 
HAS YIELDED MOSTLY DISAPPOINTING RESULTS.  THE 
CURRENT COALITION GOVERNMENT INCLUDES A COLLECTION 
OF SMALLER PARTIES, SUCH AS THE PENSIONERS' PARTY, 
WHICH, WHILE LARGELY SUPPORTIVE OF THE GOVERNMENT 
PROGRAM, IS ABLE TO TAKE THEIR POUND OF FLESH FROM 
REFORM.  AS A RESULT, THE STATUS QUO PERSISTS, 
DRIVING FURTHER GOVERNMENT BORROWING AND LIMITING 
THE RESOURCES AVAILABLE FOR KEY INVESTMENT 
ELSEWHERE.  THE GOVERNMENT HAS FINANCED ITS DEFICITS 
PRIMARILY THROUGH BORROWING AND, TO A LESSER EXTENT, 
WITH PRIVATIZATION RECEIPTS.  OVERALL GOVERNMENT 
DEBT NOW TOTALS APPROXIMATELY 55 PERCENT OF GDP; 
CROATIA'S TOTAL FOREIGN DEBT (PUBLIC AND PRIVATE) IS 
85 PERCENT OF GDP. 
 
STRONG KUNA HURTS EXPORTS; IMPORTS SURGE 
---------------------------------------- 
¶5.  (SBU) CROATIA'S IMPORTS HAVE GROWN AT A 
 
ZAGREB 00000320  002 OF 002 
 
 
CONSISTENTLY FASTER RATE THAN EXPORTS.  THAT A 
SMALL, OPEN ECONOMY SUCH AS CROATIA'S SHOULD RUN 
TRADE DEFICITS IS NOT, IN AND OF ITSELF, SURPRISING. 
HOWEVER, PERSISTENT CURRENT ACCOUNT DEFICITS 
(ESTIMATED AT 5.9% FOR 2005), COMBINED WITH CHRONIC 
FISCAL DEFICITS AND MOUNTING FOREIGN DEBT MAKE SOME 
OBSERVERS UNEASY.  THE CROATIAN CENTRAL BANK, 
ALARMED BY RAPID CREDIT GROWTH AND GROWING FOREIGN 
DEBT (MUCH OF WHICH ALSO DRIVES IMPORT GROWTH), HAS 
ACTED SEVERAL TIMES IN THE LAST YEAR TO INCREASE 
RESERVE REQUIREMENTS FOR NEW LENDING.  HOWEVER, THE 
BANK'S TOOLBOX IS LIMITED AND THE MOSTLY FOREIGN- 
OWNED BANKS HAVE FOUND WAYS AROUND THESE MEASURES, 
SUCH AS LENDING DIRECTLY FROM THEIR HOME OFFICES AND 
USING LEASING ARRANGEMENTS. 
 
¶6.  (SBU) ONE OF THE REASONS CROATIA'S EXPORT SECTOR 
PERFORMS SO BADLY IS THAT THE NATIONAL CURRENCY, THE 
KUNA, IS RELATIVELY EXPENSIVE COMPARED TO OTHER 
CURRENCIES IN THE REGION.  THE CENTRAL BANK 
MAINTAINS A MANAGED FLOAT OF THE KUNA AGAINST THE 
EURO.  THE CURRENT EXCHANGE RATE, HOWEVER, IS 
PARTIALLY A LEGACY OF STABILIZATION POLICIES IN THE 
1990S WHEN THE GOVERNMENT WAS FORCED TO RAISE 
INTEREST RATES TO CONTROL INFLATION.  OVER TIME, 
HOWEVER, EVEN AS INFLATIONARY PRESSURES ABATED, 
CROATIA'S ECONOMY HAS BECOME MORE AND MORE 
"EUROIZED."  WITH MOST CONSUMER DEBT AND MUCH PUBLIC 
DEBT INDEXED TO THE EURO EXCHANGE RATE, THE BANK HAS 
EFFECTIVELY LOST THE ABILITY TO LET THE KUNA 
DEPRECIATE SUBSTANTIALLY AGAINST THE EURO. 
 
MULTIPLE PROBLEMS; LIMITED SOLUTIONS 
------------------------------------ 
¶7.  (SBU) CROATIA'S POLICYMAKERS APPEAR TO HAVE FEW 
IDEAS ABOUT HOW TO MAKE THE ECONOMY MORE DYNAMIC. 
THIS IS ATTRIBUTABLE BOTH TO POLITICAL RISK AVERSION 
AND TO THE LACK OF SERIOUS DISCUSSION ABOUT THE 
OVERALL DIRECTION OF ECONOMIC POLICY IN THE COUNTRY. 
AS A SMALL COUNTRY HIGHLY INTEGRATED WITH THE LARGER 
EUROPEAN ECONOMY, THE CROATIAN GOVERNMENT ALREADY 
HAS FEWER OF THE TRADITIONAL LEVERS OF ECONOMIC 
POLICY AVAILABLE TO IT.  CROATIA'S CURRENT SITUATION 
LIMITS THOSE CHOICES EVEN FURTHER.  ALTHOUGH THE 
GOVERNMENT NEEDS TO CUT SPENDING AND IS UNDER 
CONSIDERABLE PRESSURE TO BRING ITS DEFICITS DOWN, 
SPENDING MEANS JOBS AND, MOST IMPORTANTLY, VOTES. 
AS A RESULT, SUBSIDIES KEEP FLOWING AND ESSENTIAL 
PRIVATIZATIONS AND RESTRUCTURINGS ARE DELAYED.  THE 
OPPORTUNITY COST OF THESE CHOICES IS EVEN HIGHER, AS 
FUNDS ARE NOT AVAILABLE TO DEVELOP MORE PRODUCTIVE 
AREAS OF THE ECONOMY THAT COULD CREATE NEEDED 
EMPLOYMENT.  LIKEWISE, CROATIA IS UNABLE TO USE 
MONETARY POLICY TO INCREASE COMPETITIVENESS.  WHEN 
THE EXCHANGE RATE AND SOCIAL CHARGES ARE COMBINED, 
CROATIAN LABOR IS UNCOMPETITIVE IN MANY INDUSTRIES, 
WHICH ALSO AFFECTS THE INVESTMENT CHOICES OF FOREIGN 
COMPANIES CONSIDERING REGIONAL STRATEGIES IN 
SOUTHEAST EUROPE. 
 
¶8.  (SBU) THE GOVERNMENT'S POLICIES APPEAR TO BE 
BASED ON THE HOPE THAT CROATIA'S ECONOMY WILL SIMPLY 
OUTGROW SOME OF THESE PROBLEMS.  CURRENT EFFORTS ARE 
LARGELY AIMED AT REDUCING BUREAUCRACY IN AN ATTEMPT 
TO CREATE A MORE INVESTOR-FRIENDLY ENVIRONMENT. 
WHILE THERE IS SOME BASIS FOR OPTIMISM IN THESE 
REFORMS, FOREIGN INVESTMENT ALONE WILL NOT GET 
CROATIA'S ECONOMY FULLY ON TRACK.  THE LONGER THE 
GOVERNMENT POSTPONES TOUGH CHOICES ON SPENDING, THE 
LONGER THE COUNTRY IS LIKELY TO BE SADDLED WITH HIGH 
UNEMPLOYMENT, DEFICITS AND DEBT. 
 
FRANK