Admission to the EU to activate Croatia's competitive advantages - Much expected from tourism, energy and transport

Croatia joined the European Union on 1 July 2013, in a time when both this country and the EU struggle to kick-start the economy again.

However, Erste Group's special report dubbed "Croatia: Success Story, Despite Currently Demanding Time" reads that the admission to the European Union is a good catalyst for reviving the country's economic growth potential.

- After long-lasting problems with growth over the last few years, it is of no surprise that we are facing optimistic expectations when it comes to EU membership. Even though the success of previous enlargement rounds seems a demanding target to match, Croatia has several competitive advantages such as geographic position, insufficiently exploited tourism potential, well-developed road infrastructure, and the energy sector in its infancy. If Croatia makes a good use of its advantages and accelerate reforms, we expect the EU membership to activate these advantages in the medium run - explains Alen Kovac, chief economist at Erste Bank Croatia.

Intensified capital flows related to EU membership are being seen as an important channel to foster new growth opportunities via fresh capital, know-how transfer and access to new markets. When addressing Croatia, one should take into account the fact that FDI inflows in Croatia were substantial over the last decade. However, where Croatia underperformed its CEE peers is in the structure. Namely, services are dominating, while manufacturing FDIs remained very scarce. Not going into the details, FDIs were channeled into non-tradeables, domestic demand dependent sectors. While this, for instance, definitely supported the robustness of the banking sector, manufacturing, job generation and exports suffered. Acceleration of privatization process, which is emphasized as one of the Government targets, would act pro FDI by ensuring fresh capital, higher efficiency and know-how transfer.

Much is expected from tourism, energy and transportation - Structural reforms remain key challenge ahead

Erste Group analysts are of the opinion that tourism will attract satisfactory interest, given that this sector has registered a significant growth since the begining of the crisis and that Croatia still has some untapped potential in this sector. The transportation sector also looks promising, considering Croatia's comparative geographic advantage. Besides, a well-developed infrastructure leaves more opportunities for EU funds to focus on other parts of infrastructure, railways and ports in particular. Agriculture and food production still depend on the economy of scale, but the government's intention to increase the use of uncultivated state-owned land is a step in a good direction. Furthermore, energy is indentified as one of the key sectors, aiming imports substitution. While energy is capital intensive, Job creation should be targeted more through the attracting vertical FDIs, predominantly in the manufacturing segment. This brings us to potentially the most important item, structural reforms, which remain the key challenge ahead.

Improvement of the business environment is necessary in order to attract new investors.

- According to international benchmarking indicators such as the Global Competitiveness Index, Corruption Perceptions Index and Doing Business Rank, Croatia is positioned as weak with respect to its regional peers, with problems being especially evident in the segments of public sector size and efficiency, rigid labor market legislation, a lack of efficiency and weak investor protection. On the other hand, Croatia scores more solidly in the segments of infrastructure and healthcare. It is encouraging that, among policy makers there is a perception of an unsatisfactory position, resulting in some efforts to improve the business climate and eliminate investment bottlenecks. Further efforts are needed to make labor market more flexible, especially given the low activity rate and surging unemployment, which as a consequence also puts pressure on fiscal performance. Lack of improvement on this front may prove costly in terms of FDI outlook, but also in utilization of EU funds, and consequently GDP performance. We therefore continue to see no alternative to reforms acceleration - says Alen Kovac.

An additional important factor would be the fact that Croatia would exit the Central European Free Trade Agreement (CEFTA), resulting in a loss of competitiveness on the CEFTA market, namely with Bosnia & Herzegovina and Serbia, due to increasing customs duties.

- We expect some negative effect from CEFTA markets in the short term, but see the EU market, with its 500 million people, as offering more potential in the mid-run. Additionally, EU membership would put competitive pressure on domestic production amid intensified imports from the EU, which would hopefully drive efficiency gains, but would also imply a demanding operating environment for a large proportion of companies - Alen Kovac stresses.

After the European Council meeting in February, the Croatian government announced that the total funds available for Croatia in the period 2014-20 would amount to EUR 11.7bn (approx. 25% of 2013 GDP). The contracting and spending of such considerable funds definitely represents an important element in defining the growth potential in the mid-run. Croatia’s track record in the implementation of the IPA pre-accession funds has often been criticized. Croatia’s slow implementation of IPA provides reason for further concern in view of the tenfold amount of funds expected after accession. Coupled with the fact that, at the beginning of the programming period, contracting and payments are usually somewhat slower and pick up after approximately a year, it seems that Croatia could expect a more significant impact from the EU funds only in the mid term. However, a prerequisite for a satisfactory result in the mid term is strengthening the institutional framework and generally acceleration of structural reforms.

As a member of the EU, Croatia faces the activation of the Excessive Deficit Procedure (EDP) on the basis of a budget deficit in excess of 3% of GDP, though the public debt trajectory also rings alarm bells with respect to the 60% of GDP threshold. Some may argue that EDP activation would deliver negative signals, but with effectively a majority of EU countries inside the EDP zone, Erste analysts see the EDP as more of an opportunity. The implied call for corrective action and for Croatia to pursue mid-term fiscal consolidation may be perceived as quasi-IMF, in the sense that it should support fiscal policy soundness and ensure more commitment to fiscal targets.

Besides, the Reinforced Stability and Growth Pacts, in the form of the six-pack, set the stage for additional fiscal measures, but also macroeconomic and surveillance actions, with the focus shifting away from nominal targets towards structural ones.

- An important pillar of the six-pack is the debt reduction rule demanding excess debt to be reduced by 1/20, which practically implies stabilizing the currently upward-leaning public debt trajectory. All in all, the six-pack will be a key anchor to fiscal stability in the mid run, which will result in a low-risk investment environment - Alen Kovac concludes.