Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 39392-HR

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A

PROPOSED SECOND PROGRAMMATIC ADJUSTMENT LOAN

IN THE AMOUNT OF EUR15O MILLION

(US$197.4 MILLION EQUIVALENT)

TO

THE REPUBLIC OF CROATIA

April 27,2007

Poverty Reduction and Economic Management Unit Europe and Central Asia Region

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CAS CEEC

CEFTA

C E M CFAA

CPAR

CNB CPF csw DfID

EC EU FDI FIAS FSAP GDP GFS HAMAG HBOR

HDZ HRK

HZOZO

GOVERNMENT FISCAL YEAR: (January 1 - December 31)

CURRENCY EQUIVALENTS (as o f April 24,2007)

Currency Unit US$1-HRK 5.455

WEIGHTS AND MEASURES Metric System

ACRONYMS AND ABBREVIATIONS

Country Assistance Strategy Central and Eastern European Countries Central European Free Trade Agreement Country Economic Memorandum Country Financial Accountability Assessment County Procurement Assessment Report Croatian National Bank Croatia Privatization Fund Centers o f Social Work Department o f International Development European Community European Union Foreign Direct Investment Foreign Investment Advisory Service Financial Sector Assessment Program Gross Domestic Product General Finance statistics Agency for SME Development Croatian Bank for Reconstruction and Development Christian Democratic Union Party Croatian Kuna

Croatian Insti tute for Health Insurance

HZ IBRD

I C R

IT IMF

ILO

MTEF NATO OED OECD

P A L PAYGO PRF R&D S A A SAL S A P SBA SME

UNDP USAID

Croatian Railways International Bank o f Reconstruction and Development Implementation Completion Report

Information Technology International Monetary Fund

International Labor Organization

Medium-Term Expenditure Framework North Atlantic Treaty Organization Operations Evaluation Department Organization for Economic Cooperation and Development Programmatic Adjustment Loan Pay As You Go Pensioners Restitution Fund Research and Development Stability and Association Agreement Structural Adjustment Loan Systems Applications and Products Stand By Arrangement Small and Medium Enterprises

United Nations Development Program United States Agency for International Development

Country Director: Anand K. Seth Sector Manager: Bernard Funck

Task Team Leader: Satu Kahkonen

FOR OFFICIAL USE ONLY

THE REPUBLIC OF CROATIA SECOND PROGRAMMATIC ADJUSTMENT LOAN

TABLE OF CONTENTS

PROGRAM SUMMARY ......................................................................................................................... i11

I . INTRODUCTION .............................................................................................................................. 1

I1 . RECENT POLITICAL AND ECONOMIC DEVELOPMENTS .................................................. 1

A . B . C . D . E . F .

Recent Political Developments ............................................................................................... 1 Recent Economic Developments ............................................................................................ 2 Investment Climate ................................................................................................................ 5 Governance.. ......................................................................................................................... 6 Poverty ................................................................................................................................. 6 Status o f the IMF Program in Croatia ...................................................................................... 7

I11 . GOVERNMENT’S DEVELOPMENT PRIORITIES .................................................................... 7

I V . WORLD BANK GROUP STRATEGY AND PROPOSED PAL .................................................. 8

A . Link to CAS .......................................................................................................................... 8 B . Analytic Underpinnings o f the Program .................................................................................. 8 C . Lessons Learned from Prior Operations .................................................................................. 9 D . Coordination with Other Development Partners ..................................................................... 10 E . Consultations with Stakeholders ........................................................................................... 10 THE PROPOSED PAL REFORM PROGRAM ........................................................................... 10

A . Objectives o f PAL ............................................................................................................... 10 Overview o f P A L ................................................................................................................ 11 Overall Assessment o f Progress in Implementing P A L Reforms since P A L l ........................... 12

Pillar I: Improving Investment Climate ................................................................................ 17 Pillar 11: Strengthening Governance ..................................................................................... 22

V .

B . C . D . Overall Progress Achieving Outcome Goals since P A L l ........................................................ 16 E . F . G . Pillar 111: Enhancing Fiscal Sustainability o f Sector Programs ............................................... 26

V I . OPERATION IMPLEMENTATION ............................................................................................. 31

A . B . C . D . E . F .

Poverty and Social Impacts .................................................................................................. 31 Fiduciary Aspects ................................................................................................................ 32 Disbursement and Audit ....................................................................................................... 33

Implementation and Monitoring ........................................................................................... 35 Environmental Aspects ........................................................................................................ 33

Risks and Risk Mitigation .................................................................................................... 35

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties . I t s contents may not be otherwise disclosed without Wor ld Bank authorization .

1

THE REPUBLIC OF CROATIA SECOND PROGRAMMATIC ADJUSTMENT LOAN

CONTENTS (cont'd)

SCHEDULES

Schedule 1: Schedule 2:

ANNEXES

Annex 1: Annex 2: Annex 3: Annex 4: Annex 5: Annex 6: Annex 7 : Annex 8: Annex 9: Annex 10:

FIGURES

Figure 1: Figure 2: Figure 3: Figure 4: Figure 5: Figure 6:

TABLES

Table 1: Table 2:

BOXES

Box 1: Box 2:

Letter o f Development Policy PAL Policy Matrix

Croatia - At a Glance Croatia - Social Indicators Croatia - Key Economic Indicators Croatia - Key Exposure Indicators Croatia - Operations Portfolio (IBRD and grants) Croatia - Statement o f IFC's - Held and Disbursed Portfolio for Croatia Croatia - Selected Indicators o f Bank Portfolio Performance and Management Croatia - IFC and MIGA Program, FY 2002-2005 Croatia - Summary o f Non-lending Services Fund Relations Note

Catching up with the EU Comparison o f Fiscal Deficits, percent o f GDP Evolution o f Increased External Vulnerability Subsidies (received during the last three years as percent o f total annual sales) Selected Governance Indicators in 2005 Corruption Perception Index (0-10)

Summary o f the Proposed Reform Program Anticipated and Final PAL2 Prior Actions

Relatively Sound Banking System Application o f Good Practice Principles on Conditionality in P A L

The Bank task team includes Satu Kahkonen (Task Team Leader, ECSPE), Sanja Madzarevic-Sujster, Piet van Heesewijk (ECSPE); Ir ina Kichigina (LEGEC); Zoran Anusic, Inguna Dobraja, Daniel Dulitzky (ECSHD); Robert Gourley (ECSPF); Stjepan Gabric, Agnieszka Grudzinska, Paula Lytle, Karin Shepardson (ECSSD). Peer reviewers are Mamta Murthi (ECSHD), Edward Mountfield (PRMED) and Albert Martinez (QAG).

11

THE REPUBLIC OF CROATIA

SECOND PROGRAMMATIC ADJUSTMENT LOAN

Borrower:

Amount:

Terms:

Description:

Benefits:

Risks:

PROGRAM SUMMARY

The Republic o f Croatia

EUR15O mi l l i on (US$197.4 million equivalent) to be withdrawn in two tranches, EURlOO mi l l i on first tranche and E m 5 0 m i l l i on second tranche

f ixed spread LIBOR-based loan, commitment link, level repayments payable in fifteen years including a five-year grace period

The proposed loan i s the second in the series o f three Programmatic Adjustment Loans (PAL), which a im to support enhanced economic growth through: (i) improving the investment climate, and (ii) reducing the size and improving efficiency o f the public sector. Ful f i l lment o f EU accession criteria and successful EU integration cal l for intensive structural and institutional reforms, and the PAL series supports the Government in that effort.

PAL specifically supports:

Improvements in the investment climate by completion o f the privatization or liquidation o f state-owned enterprises, improving financial discipline o f enterprises, reducing the cost o f doing business, and strengthening the judiciary.

Efforts to improve governance by rationalizing and improving efficiency o f public administration, and improving public expenditure management.

Measures to enhance fiscal sustainability of sector programs by addressing health financing, rationalizing social benefits, improving fiscal and social sustainability o f the pension system, and fiscal sustainability o f railways operations.

The PAL series helps the Government implement a medium-term reform program to achieve i t s goals o f enhanced economic growth and progress towards EU accession. The reforms supported are part o f EU accession requirements, and o f the Government’s Strategic Development Framework and Pre-Accession Economic Program. They a im to strengthen the public sector’s capacity to carry out i t s ro le more effectively, and provide an enabling environment for private sector growth.

Several r i sks attend the reform program under PAL:

Polit ical risks remain high as the country has a coalition Government with a mere one seat majority in Parliament, and several proposed reforms are ambitious and polit ically challenging. Also, the next Parliamentary

... 111

elections are scheduled for November 2007, and the country i s entering a pre-election period, which raises a r i s k o f contemplation and adoption o f fiscally unsustainable policies and investments. However, reforms to be supported under PAL are consistent with the EU accession agenda, whch i s expected to somewhat mitigate the risk. Further, to mitigate the risk o f other policy reversals during the 2007 pre-election period after the PAL2 Board, the whole Bank program in Croatia has been put on the line: if the P A L supported reforms will be reversed in 2007, the Bank program wil l immediately move to the low case scenario with further lending curtailed.

0 Capacity weaknesses could impede implementation o f proposed reforms. Capacity i s uneven and limited in several ministries, which may hinder the reform effort. However, investment projects that complement PAL and technical assistance by other donors are designed to mitigate some o f the capacity constraints.

External shocks that have adverse effects on regional stability or access to finance could seriously harm the reform effort. Given Croatia’s heavy reliance on tourism revenues and exports to Europe, i t i s vulnerable to any deterioration in regional stability or EU growth slowdown. However, P A L supported reforms to improve the investment climate are expected to mitigate the risk through diversification o f economic activities.

Given the high degree o f euroization o f the Croatian economy, the Croatian financial sector remains vulnerable to exchange rate risks. The Croatian National Bank has, however, taken several measures to control the risk by discouraging foreign borrowing by banks, monitoring foreign exchange exposures o f bank clients and strengthening supervision both o f banks and joint ly with HANFA o f non-banking financial institutions.

EURlOO mi l l ion will be disbursed as the first tranche upon Loan effectiveness, and EURSO mi l l ion as the second tranche upon satisfactory completion o f second tranche conditions.

Estimated

Disbursements:

Project ID Number: PE-PO94341

iv

IBRD PROGRAM DOCUMENT FOR

A PROPOSED SECOND PROGRAMMATIC ADJUSTMENT LOAN TO

THE REPUBLIC OF CROATIA

I. INTRODUCTION

1. This Program Document presents the Second Programmatic Adjustment Loan (PAL2) to the Republic o f Croatia in the amount o f EUR15O mil l ion (US$197.4 mi l l ion equivalent). The proposed operation builds on the f i rs t PAL (PALl), and it continues to be the centerpiece o f Bank’s assistance to Croatia.

2. ’ The Government has made satisfactory progress in implementing the PAL program and all PAL2 prior actions have been fully met. The reform program supported by PAL2 aims to enhance economic growth in Croatia through: (i) improving the investment climate; and (ii) reducing the size and improving efficiency o f the public sector. The Croatian Government i s aspiring to j o in the European Union (EU), and fulfillment o f EU accession criteria and successful EU integration call for intensive structural and institutional reforms across sectors. The proposed PAL2 supports the Government in these efforts.

3. The proposed reform program has been developed jointly with the Government, and incorporated in Croatia’s Strategic Development Framework and Pre-Accession Economic Program, which lay out the country’s comprehensive economic policy. The program has been coordinated wi th other development partners, in particular wi th the European Commission (EC) to ensure consistency with EU accession requirements, and the International Monetary Fund (IMF). Several other partners (SIDA, USAID, UNDP, DflD) have financed technical assistance required for the implementation o f reforms.

11. RECENT POLITICAL AND ECONOMIC DEVELOPMENTS

A. Recent Political Developments

4. The center-right Croatian Democratic Union party (HDZ) returned to power in 2003, and a new coalition Government was formed. The new Government reaffirmed Croatia’s European orientation, aiming to make EU accession a reality. Croatia’s achievements under the Partnership for Peace process in the past couple o f years are at the same time aiding the country’s quest to gain an invitation to NATO membership in 2008.

5. In October 2005, Croatia opened EU accession negotiations. Preceding that, in June 2004, the European Council granted Croatia a candidate status and endorsed the EU Accession Negotiation Framework, but delayed the opening o f accession negotiations until some pre-conditions were met. The f i rs t phase o f negotiations-the screening process-was finished in October 2006, and two out o f the 33 chapters o f the accession treaty were provisionally closed. For another four chapters closing benchmarks were set. The key economic issues that the Government would need to resolve prior to potential EU accession are consistent enforcement o f market competition and state aid rules, increasing efficiency o f public administration, stepping up anti-corruption measures, and judiciary reform.

6. relaxation are expected during the pre-election period.

The next Parliamentary elections are scheduled for November 2007. Pressures for fiscal

1

B. Recent Economic Developments

7. Benefiting from successful economic transformation after independence and the start o f EU accession negotiations, economic activity has been robust in the past few years. Inflation has been modest despite increased o i l and commodity prices, helped by central bank policy to maintain exchange rate stability. The adverse terms o f trade shock has, however, contributed to the widening o f the current account deficit, even though fiscal policy has tightened since 2003.

8. Real GDP growth, after moderating in 2004 accelerated to 4.3 percent in 2005 and 4.8 percent in 2006 (see Figure 3). Growth i s

Growth recovered in 2005, and continued to be strong in 2006.

projected to slightly slowdown to 4.5 percent in 2007. Inflation has remained low at 3.2 percent, despite increased o i l prices. Growth has been driven primarily by the growth o f gross fixed investment (3.2 percentage points or 1.8 percentage point increase from 2005), followed by household consumption (contributing with 2.1 percentage points o f GDP). Government consumption increased somewhat in 2006 as well, but i ts contribution to total real growth has remained low. Compared to 2005, exports o f goods and services grew at a faster pace in 2006, but the growth o f imports also accelerated to 7.3 percent and exceeded the export growth.

9. Fiscal consolidation has taken place. Fiscal policy has tightened in the past few years to arrest the growth o f public debt: the fiscal deficit declined from 6.3 percent in 2003 to 3.9 percent in 2005. The 2006 general government deficit was 3.1 percent o f GDP,' excluding the deficit o f HBOR and the additional one percent o f GDP allocated for repayment o f pensioners' debt, which has been financed by privatization receipts.* While noteworthy, this i s s t i l l above a sustainable level by about one percentage point o f GDP, and the size o f the state remains high by international standards3 at about 48.5 percent o f GDP. The public debt-to-GDP ratio was at 49.6 percent at end 2006.

Figure 1: Catching Up with the EU, GDP per capita in PPS, EU25=100

, 1 1250 - 1100 108 6 108 1 i

2000 2004 2006

i m a - 1 5 EL8 rn Dcatk3

Source: Eurostat

Figure 2: Comparison o f Fiscal Deficits, percent o f GDP

I - 6 1 I I -7

2003 2004 2005 2006e

Source: Eurostat, Croatian Ministry o f Finance

10. because the scope for increasing tax revenues i s limited, and relying on privatization receipts to finance deficits i s not a viable medium-term strategy, since they are expected to decline after Telecom IPOs. The overall tax burden in Croatia i s high compared to most EU countries: Croatia taxes directly and

Further fiscal consolidation i s s t i l l required

' Includes a l l loca l government units. * These two items wou ld add 1 .I percent o f GDP to the deficit and expenditure levels.

The average general government spending for ten new EU member states was 39 percent o f GDP in 2005. 3

2

indirectly 39 percent o f i ts gross value added.4 However, without cuts in public spending, tax reduction i s not feasible. Accordingly, the government i s pursuing further fiscal consolidation and targeting a fiscal deficit o f 2.8 percent o f GDP in 2007.

1 1. After cooling down in 2003-2004, domestic credit expansion has picked up again, driven by the shvt in the government borrowing towards the domestic market. Domestic credit growth at 20 percent in 2005 was eight percentage points higher than monetary authorities’ target. Loans to government and households rose by 44.1 percent and 20.2 percent, respectively. Since a major share o f deposits i s held in foreign currency, the financial sector remains vulnerable to exchange rate shocks. The Croatian National Bank (CNB) has taken several measures to discourage foreign borrowing by banks and monitor foreign exchange exposures o f the banks’ clients, including the increase o f the marginal reserve requirement on new bank borrowing from abroad to 55 percent; increasing risk weights on un-hedged foreign-currency denominated and indexed loans; introducing quarterly reporting requirements for such loans; issuing new guidelines to banks on managing household and currency-induced credit risk, including a 75 percent loan-to-value ratio for mortgage loans; high risk weights for loans not checked against the credit bureau; and broadening the base o f the foreign-exchange liquidity requirement to cover instruments indexed in foreign currency. To prevent banks from resorting to issuance o f securities, CNB introduced in January 2006 a special interest-free 55 percent reserve requirement on commercial banks’ liabilities arising from issued securities (see also Box 1 below). In addition in 2007, CNB i s aiming to limit credit growth to 12 percent through a mandatory purchase of CNB notes by banks, whose credit growth exceeds the 12 percent limit.

Box 1: Relatively Sound Banking System The latest Bank-Fund Financial Sector Assessment Program (FSAP) was completed in October 2002, and the authorities have implemented most o f its recommendations. An FSAP-update i s being discussed between the Government, IMF, and the World Bank.

The Croatian banking system, despite i t s rapid expansion, i s relatively sound. Since 1996, the system has undergone major consolidation, and banking regulation and supervision have been improved and i d l y harmonized with the EU. By 2002, most banks were privatized. Foreign ownership i s widespread, with foreign banks accounting for 91 percent of bank assets. Only two banks (including the postal bank) remain state-owned. Minimum capital adequacy i s 10 percent, and banks are reported to be well capitalized (at 12.9 percent). The average interest margin i s declining, and was below 4 percent in 2006. Credit i s relatively high at 68 percent of GDP in 2006, with more than 75 percent going to the private sector. At the end 2006, non-performing loans had declined to 3.5 percent of total loans. The share o f foreign exchange loans (including loans indexed to foreign exchange) in total loans has declined from 80 percent in 2003 to 71.7 percent at end 2006. Overall, there i s a relatively high level o f depth and resource mobilization.

The central bank i s independent, which was further strengthened in 2006 by the adoption o f a new CNB Act consistent with EU requirements. The Base1 Core Principles are also consistently adhered to. A deposit insurance scheme i s in place, and prudential requirements are consistent with consolidated supervision requirements. Whi le the Croatian National Bank i s responsible for the regulation and supervision o f the banking sector, the 2005 law on the integrated supervision of non-bank financial institutions established a new regulator (HANFA) for the supervision of securities exchange, insurance companies, investment and pension funds, and leasing companies. A Memorandum o f Understanding between the two supervisors was signed in September 2006, and the joint supervision o f most financial conglomerates has started.

The average tax burden for the ten new EU member states was 30 percent o f GDP in 2005.

3

Figure 3: Evolution o f Increased External Vulnerability, 2000-2006

Real GDP Growth has been strong ...

14

, demand 8 / 8

0 1 0 -2 -2

2000 2001 2002 2003 2004 2005 2006

Credit growth has picked up, funded in large part by foreign borrowing ...

5 t

40

35

30

25

20

15

10

2000 2001 2002 2003 2004 2005 2006

... and external debt increased further.

... and inflation moderate.

6 6

5 5 (12-month percent change)

0 *1: 2000 2001 2002 2003 2004 2005 2006

... while the current account deficit has widened. ..

12 (In percent o f GDP)

Current

2000 2001 2002 2003 2004 2005 2006

Public debt declined in 2006.

(In percent o f GDP)

52 5 1 50 49 48 47 46 45

2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006

Sources: CROSTAT, Ministry o f Finance, Croatian National Bank; and World Bank staff estimate.

12. These domestic policy measures have not been sufficient to curtail the external current account deficit. The current account deficit increased to 6.6 percent o f GDP in 2005 from 5.2 percent in 2004, and continued to grow to 7 percent o f GDP in 2006, despite strong growth in exports o f goods (excluding ships) and services. The trade deficit widened by 11.3 percent compared to 2004. The debt generating current account deficit (current account deficit plus net FDI) remained moderate at 2.7 percent o f GDP in 2005 and turned to surplus o f 0.4 percent o f GDP. FDI inflows stood at 5.1 percent o f GDP in 2005, which was double the 2004 level, and increased to USD3.3 billion or 7.8 percent o f GDP

4

in 2006. FDI financing i s projected to continue strong in 2007, given the upcoming Telecom P O and the planned sale o f rest o f the companies in the Croatian Privatization Fund portfolio.

13. External debt has been broadly stabilized, but external vulnerabilities remain. Gross external debt (in EUR) stood at 84.7 percent o f GDP in 2006, up from 79.4 percent at end 2004, owing to strong capital inflows to domestic banks. In USD terms, the external debt-to-GDP ratio declined by about nine percentage points o f GDP to 78.5 percent in 2005, but rose to above 89.0 percent o f GDP by end 2006. In 2005, in order to reduce foreign indebtedness, the Government shifted from foreign to domestic sources o f finance, but since domestic banks are re-lending loans from foreign mother banks, the public sector borrowing requirement has continued to indirectly contribute to the external debt growth.

14. Continued external vulnerability poses a risk to macroeconomic stability and leaves the Government with little room to maneuver in the event of shocks. Given the high degree o f euroization o f the Croatian economy, external shocks could potentially cause substantial damage. Hence, further fiscal consolidation and reduction o f external debt remains critical to reducing Croatia's macroeconomic vulnerability over the medium term. As will be discussed later, the PAL series i s aiming to mitigate these macroeconomic r isks by supporting structural reforms facilitating further fiscal consolidation and promoting private sector activity.

15. The Government's macroeconomic framework for 2007 is broadly satisfactory. As mentioned earlier, the authorities are targeting only slight further fiscal consolidation during the election year, with a fiscal deficit target o f 2.8 percent o f GDP. More ambitious further fiscal consolidation i s expected in 2008.

C. Investment Climate

16. State presence in the economy remains large. The 2006 E B ~ Transition Indicators suggest that the private sector continues to account for about 60 percent o f the economy in Croatia, which i s below the level o f any EU8 country. However, the national accounts data suggests that the private sector share o f GDP rose to about 69 percent in 2006. While there have been significant improvements, a share o f public and state-owned enterprises s t i l l remains to be privatized or '' liquidated, and, despite cuts, direct state aid to the o , enterprise sector i s still high compared to the EU average.

17. The cost of doing business has declined. In 2006, Croatia climbed up 13 positions to the 51st place on the global competitiveness ladder o f the 125 countries rated by the Wor ld Economic Forum. Also, the 2006 Cost o f Doing Business assessment indicates improvements in the overall business climate and ranks Croatia up by 10 positions. Over time, the reforms taken in the past couple o f years can also be expected to increase the share o f the private sector in the economy. The regulatory framework governing the private sector remains cumbersome nonetheless, and the judicial system inefficient as property rights are weak compared to OECD countries. To facilitate further expansion o f the private sector, strengthening o f the investment climate i s required. Further reforms to streamline the regulatory regime governing the private sector, and strengthen the judicial system are already underway.

Figure 4: Subsidies (last three years as percent Of

i95

i ---+ -_ -1_1 _-rn - (l__**l_ll*-""--ll_I- 1

1 i

111 -11.111 '"-*"'." 11111111111-1 ""2

0

s , * + Y : a 'an sq*3"alctt:. c t r n

Source. BEEPS, WE3 and EBRD

5

D. Governance

18. The results of the EBRD-World Bank Business Environment and Enterprise Performance Survey (BEEPS) indicate that corruption has declined in Croatia since 1999. The Parliament approved a new Anti-Corruption Program 2006-2008 in 2006, with special attention devoted to areas such as judiciary, health services, local government, and public administration, where corruption i s considered to be most prevalent. An ambitious action plan, which covers all the ministries, was subsequently prepared. The capacity o f the Office for the Prevention o f Corruption and Organized Crime has been strengthened, and it has signed a cooperation agreement with the Ministry o f Finance, and the tax administration. Reforms taken and launched include the adoption o f ethics codes, codes o f conduct in the public sector, conflict o f interest legislation, and public procurement and state aid legislation, depoliticization o f public administration, reform o f political party financing, and direct election o f city mayors and county prefects. Effective prosecution o f malfeasance will require strong political commitment, which will be tested as implementation proceeds. However, the monitoring by EC can be expected to help Croatia stay on course.

Figure 5: Selected Governance Indicators in 2005 I 1 100

I 90

40 30

20 10

OGOvernmnt Efectireress sReaulatl .Control

1 W15 We &bars OoaUa

Source: World Bank, BEEPS - Governance indicators Notes: EU-8 includes Czech R.. Estonia, Hungaty, Lithuania, Latvia, Poland, Slovakia and Slovenia Other SEEC includes Albania, Bosnia and Herzegovinn, Macedonia. Montenegro, Serbia.

Figure 6: Corruption Perception Index (0-10)

E U I B

2005

Croatia I4 2006

WIO #

I Other SEEC

0 2 4 6 8 1 0

Source: Transparency International Notes: EUIO includes EU8, Bulgaria and Romania

E. Poverty

19. Low and stagnant poverty. The poverty analysis conducted in 20065 indicates that poverty in Croatia i s relatively low and shallow, but has not changed since the last poverty assessment in the late 1990s. Four percent o f the population l i ve on less than USD4.30 a day (at purchasing power parity), and about 11 percent live on about USDlO a day, which the study suggests i s an absolute poverty line for Croatia. Another ten percent o f the population i s at risk o f poverty, as their average consumption i s less than 25 percent above the poverty l ine. About one percent o f the population faces severe deprivation. The poverty gap i s about 2.6 percent. The report estimated that to lift al l poor out o f poverty wi th perfect targeting o f assistance would cost only about 0.7 percent o f GDP. At the same time, total social benefit spending was at 3.8 percent in 2006 in Croatia, o f which only 0.26 percent o f GDP was spent on means-tested poverty benefits. The results also showed that there are no significant differences in the prevalence o f poverty by gender. Income inequality measured by the Gini coefficient was 0.25 in 2004, which i s on par with the average o f advanced transition countries. Household size, education, age, and employment status o f the household head are important correlates o f poverty.

The analysis was based on the 2002-2004 household budget surveys.

6

20. Relatively high unemployment. A t only 55 percent6, Croatia’s employment rate was in 2005 one o f the lowest in Europe, and the proportion o f long-term unemployed (that is, workers without jobs for 12 months or longer) i s higher than in all EU countries except Poland and Slovakia. The low employment rate i s a reflection o f a relatively l ow labor force participation rate among the worlung age population (63.2 percent), and relatively high unemployment rate (about 13 percent, using the ILO definition o f unemployment). The job creation rate’ in Croatia i s 3.5 percent, which i s l o w compared to about ten percent in Lithuania and seven percent in Bulgaria. Furthermore, women and youth face clear disadvantages in the labor market. Women have higher unemployment rates and lower wages than male labor market participants. Employment rates among youth and average earnings are particularly low- fewer than one in four people aged 15-25 years have jobs, and the unemployment rate for this age group i s three times that o f the age group 25-50.

21. Looking ahead, the task o f faster external income convergence with the EU will be challenging, and wil l require both faster job creation and flexibility in the allocation o f jobs and workers in the economy.8 This further underscores the need to strengthen the enabling environment for private sector growth. This will also help improve living conditions in lagging regions.

F. Status of the IMF Program in Croatia

22. The Stand-by Arrangement (SBA) with the IMF for Croatia has been successfully completed, and the Government does not intend to request a successor arrangement. The f i rst and second reviews experienced delays, and the third review was concluded on September 29, 2006. The objective o f SBA was to reduce external vulnerabilities by narrowing the domestic saving-investment gap and stabilizing the external debt-to-GDP ratio. This was to be done through fiscal and quasi-fiscal adjustment during 2004-06. Although, all end-September quantitative performance criteria, except the one for the general government arrears, were met for the third review and fiscal consolidation has taken place, the reduction o f external debt, which was the ultimate goal o f the program, has remained elusive, though the level o f external debt seem to have broadly stabilized.

111. GOVERNMENT’S DEVELOPMENT PRIORITIES

23. In August 2006, the Government adopted a Strategic Development Framework (SDF) for 2006- 2013. According to SDF, the goal o f the Government i s to achieve social prosperity through growth and employment in a competitive market economy, acting within a modern European welfare state. The aim i s to increase the average GDP growth rate to six percent by 2013, in order to facilitate convergence to the average EU25 income per capita at PPP.’ To achieve this goal, the Government plans to: (i) complete the unfinished transition process, which includes redefining the role o f the state, completing privatization and restructuring processes, and improving investment climate; (ii) develop infrastructure, including ICT, improving education outcomes, R&D linkages to the business sector, increasing flexibility o f labor markets, and strengthening social cohesion; and (iii) sustain and promote macroeconomic stability, environment and regional development, and integrated financial services.

Refers to the employed as a share o f the working age population (age 15-64). ’ The job creation rate refers to the share o f new jobs in total employment. * Labor market reforms are not part o f the PAL program, since a series o f labor market reforms were supported under the previous Structural Adjustment Loan (SAL) and it was important to see the impact o f those reforms before proceeding with new ones. ’ Croatia’s per capita income at PPS i s currently 56 percent o f the EU25 average, if corrected for the unreported economy.

7

IV. WORLD BANK GROUP STRATEGY AND PROPOSED PAL

A. Link to CAS

24. The Bank Group’s Croatia Country Assistance Strategy (CAS) for 2004/05-2007/08 was presented to the Board in December 2004 (Report No. 30717-HR). The goal o f the CAS i s to support Croatia’s efforts to: (i) improve macroeconomic stability through greater efficiency/effectiveness o f public expenditure; (ii) promote private sector-led growth; (iii) enhance broad participation in growth; and (iv) promote sustainable natural resource management.

25. The series o f Programmatic Adjustment Loans (PAL) i s the centerpiece o f CAS. Successful EU integration calls for governments to launch intensive structural and institutional reforms across sectors. The Bank has found that the most effective tool for supporting this ambitious effort, especially in EU accession countries, i s with a comparable instrument, such as PAL, which supports key structural and institutional reforms across a range o f sectors. A PAL type instrument can provide a vehicle for inter- ministerial collaboration around a clear policy reform agenda with clear outcomes, performance benchmarks, and monitorable indicators against which to assess progress during implementation, thus sending clear and predictable signals to the international community.

26. To maximize the impact o f the PAL series, the Bank has complemented it by investment loans, and analytical and advisory services in Croatia. These activities focus on social protection, education, and health sector reforms, and revitalization o f war-affected areas.

B. Analytic Underpinnings o f the Program

27. following analysis:

The P A L series i s based on a series o f economic and sector work on Croatia. This includes the

28. Country Economic Memorandum: P A L i s partly based on the results o f the Croatia Country Economic Memorandum (CEM) completed in July 2003. C E M analyzed reforms and economic policy options to promote sustainable growth, while ensuring that Croatia complies with the requirements o f the Stabilization and Association Agreement for EU integration. The report has guided the overall PAL reform framework and prioritization. However, to avoid overload and ensure effectiveness, P A L supports only a subset o f CEM recommendations.

29. Public expenditure management: In addition to the C E M analysis, preparation o f the public expenditure management component has been guided by the findings o f the Public Expenditure and Institutional Review o f 200 1, and an assessment o f Croatian Government’s debt management practices in the context o f the Joint BanWund Program on Central Government Debt Management and Debt Market Development. A new Public Finance Review was completed in spring 2007.

30. Financial management and public procurement: A Country Financial Accountability Assessment (CFAA) and Country Procurement Assessment Report (CPAR) were carried out in 2004- 2005. Key issues emerging from CFAA and CPAR have been reflected in the program.

3 1. Private sector development: The component focusing on investment climate has utilized the results o f (i) the FIAS studies on administrative barriers to foreign investment; (ii) Cost o f Doing Business assessments; and (iii) a real sector study on Croatia. Further, an assessment o f Government’s export and SME promotion programs has been carried out.

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32. Health: The proposed component on health financing i s underpinned by analytic work on health financing. The Croatia Health Financing Study, which was completed in June 2003, analyzed the current financing o f the sector and made recommendations for reform.

33. has been ongoing and guiding the design o f the pension component.

Pension: Informal analytic work on the pension sector, utilizing social insurance modeling tools,

34. Poverty and living standards analysis: A new poverty and living standards assessment was carried out in Croatia in 2006. The results o f the assessment have influenced the reform program on social benefits and health financing.

35. Poverty and social impact assessment: A social impact assessment o f shipyard restructuring plans proposed by shipyard management was conducted on two shipyards (Brodotrogir and Kraljevica) in 2006, and the results are expected to feed into the Government’s preparation o f the national shipyard restructuring plan and the accompanying social impact mitigation plan.

36. guided the preparation o f the enterprise subsidy reduction plan.

Enterprise subsidies: An inventory o f enterprise subsidies was carried out in 2004-2005, and

37. Railways: A framework paper for proposed railways reforms was prepared by the Bank in April 2004, and it had guided the work on the railways component. In addition, the Bank commissioned a study on restructuring o f Croatian railways in 2005, which has also shaped the railway reform dialogue.

38. Policy Notes: In the past couple o f years, the Bank has also prepared a series o f policy notes as the work on PAL has moved forward to guide the design o f reforms in select areas. This includes policy notes on local government pay and employment, fiscal decentralization, the use o f environmental audits in the privatization process, and benchmarking o f Croatian shipyards.

39. Workshops: To share lessons learned from other countries, in particular from EU, a series o f workshops has been organized in Zagreb on topics o f interest to the Government in the past two years. For example, workshops on public administration, judicial reform, fiduciary systems, health financing, education, land registration, fiscal decentralization, and investment climate have been held.

C. Lessons Learned from Prior Operations

40. Country Assistance Evaluation: OED conducted an evaluation o f Bank assistance to Croatia in 1991-2003. The report rated the effectiveness o f Bank’s assistance mixed, with overall outcome o f the Bank assistance program having improved since FYOl.

41. The report emphasizes that adjustment and assistance programs should not be pursued when the Government i s unconvinced o f the need for reform. I t points out that large infrastructure project are not necessarily beneficial in the absence o f related policy reforms. The report also stresses the need to: (i) closely supervise operations; and (ii) be ready to modify or cancel them if necessary, rather than allow faulty implementation to proceed. The following areas were highlighted as priorities for future Bank assistance:

rationalization and retargeting o f public expenditure in line with public revenues to contain debt;

improving growth by ensuring that privatization o f state-owned enterprises, or re- privatization o f failed enterprises which are reverting to Government ownership, i s successful, and for example not favoring insider buy-outs; and

9

improving core functions o f government, public administration, and the judicial sector.

42. Implementation Completion Report of SAL: An Implementation Completion Report (ICR) on SAL was completed in the spring 2004. The ICR provides an overall positive assessment o f the operation, and commends i t s focus. S A L focused only on three major areas (fiscal consolidation, improving the business climate, and improving labor market flexibility), instead o f attempting to cover all major sectors. The report highlighted judicial reform as the priority for Bank’s future assistance.

D. Coordination with Other Development Partners

43. Coordination with I M F : IMF i s concentrating on macroeconomic issues in Croatia, focusing specifically on short- and medium-term macroeconomic stability, and measures to reduce external debt. The Bank has been coordinating activities with the IMF staff In general, structural benchmarks have been covered by PAL, though the structural component o f the recently expired SBA focused on debt and public expenditure management and on select issues, where joint Bank-IMF effort was considered desirable.

44. Coordination with EC: The P A L series i s coordinated with EC that welcomes the P A L support for EU accession related reforms. In particular in the areas o f public administration, public expenditure management, environment, and judicial reform the Bank and EC activities are closely coordinated. The Bank i s also working closely with EC to identify opportunities for accessing EU grant funds for technical assistance and other financing relevant to PAL-supported institutional capacity building.

45. Partnership with Other Multilateral and Bilateral Development Parners: P A L i s also closely coordinated wi th other donors to Croatia, in particular USAID, UNDP, Netherlands, SIDA, DfID, and EBRD. For example, SIDA has provided a sizeable trust fund to finance technical assistance in the area o f public administration; DfID as well has been supporting public administration reform; and UNDP has financed the development o f the social impact assessment methodology. The work on privatization has been carefully coordinated with USAID, which has funded assessments o f two draft shipyard restructuring plans. In general, in a number o f areas, Bank and other donors are carefully dividing the work to ensure complementarity o f actions and to reap synergies.

E. Consultations with Stakeholders

46. At the start o f the PAL series, consultations with various Croatian stakeholders-government, private sector, trade unions, NGOs, other development partners-were conducted to identify the key reform areas. As the implementation o f the program has proceeded, a series o f consultation have been carried out in particular with trade unions to explain and fine-tune the proposed measures to mitigate the social impacts.

V. THE PROPOSED PAL REFORM PROGRAM

A. Objectives o f PAL

47. The objective o f the P A L series i s to enhance economic growth in Croatia through (i) improving the investment climate, and (ii) reducing the size o f and improving the efficiency o f the public sector. This requires fiscal adjustment and consolidation, which i s a theme running through the proposed operation. The PAL series i s designed to specifically mitigate Croatia’s external macroeconomic vulnerabilities discussed earlier. The series also supports the Government in i t s EU accession and integration efforts, and helps ensure that key economic reforms under the acquis are effectively implemented and enforced.

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48. The f i rs t single-tranche PAL (PAL1) for Croatia was approved by the Board in September 2005.’’ P A L l established a medium-term policy and institutional reform program across sectors, with policy measures and outcome targets. The program has been adjusted and refined under PAL2 based on changes in the Government’s priorities and on the lessons learned from program implementation under P A L l . The key changes are discussed below.

B. Overview o f PAL

49. Reform ureus: The reform program supported by the PAL series i s built on three pillars: (i) improving investment climate; (ii) strengthening governance; and (iii) enhancing fiscal sustainability o f sector programs. Table 1 summarizes the pillars, and reform areas and actions covered under each o f them. The specific reforms to be supported in each area are detailed in the Government’s Letter of Development Policy (see Schedule I) and the PAL policy matrix (see Schedule 2), which focus on actions that are critical for the reform process and achievement o f the set outcome goals; and which the Government would have difficulties moving forward without external support.

50. The program i s in l ine with Croatia’s Strategic Development Framework and Pre-Accession Economic Program, and there i s a broad ownership o f the program at the highest level o f Government. Some o f the reforms supported, such as privatization and enterprise state aid reduction, aim to complete Croatia’s transition to a well-functioning market economy, which i s one o f Government’s stated goals. The other reforms further Croatia’s EU accession objective. The sections to follow will discuss each pillar and reform area in more detail, and are intended to be read together with the policy matrix.

5 1. PAL program:”

Expected overall PAL outcomes: The following overall outcomes are expected as a result o f the

General government expenditure reduced from 51.3 percent o f GDP in 2003 to 46 percent o f GDP in 2008, and the fiscal deficit from 6.4 percent o f GDP in 2003 to 3.0 percent o f GDP in 2008.

Private sector share in GDP increased from 60 percent in 2003 to about 70 percent o f GDP in 2008; and

FIAS and Cost o f Doing Business assessments indicating improved investment climate in 2008.

0

0

I’ P A L l was prepared under OD 8.60 since its preparation started before OP 8.60 became effective. I’ I t is important to note that the above outcome targets are stretch goals. They should not be used rigidly and in isolation as guideposts to measure the results o f the program, since factors beyond the control o f P A L w i l l also affect their achievement. H o w each reform area i s projected to contribute to fiscal consolidation i s reflected in the expected results o f each program component. While the projected fiscal impact o f some reforms can be quantified, for some reforms-such as judicial, public expenditure management, and administrative and regulatory reforms- that i s not feasible. Also reforms such as privatization and railways restructuring contribute to fiscal consolidation primarily through reduced state aid levels.

Table 1: Summary of the Proposed Reform Program

Improving Investment Climate

Pillar Objectives Reform Areas Actions Privatization and liquidation o f state- owned enterprises

Strengthening Governance

Enhancing Fiscal Sustainability o f Sector

Programs

Improving financial discipline o f enterprises Reducing cost o f doing business

Strengthening the judiciary

Rationalizing and improving efficiency o f public administration

Improving public expenditure management Health financing

Reform o f social benefits

Improving fiscal and social sustainability o f the pension system

0

0

0

0

0

0

0

0

0

0

0

0

0

Sell or cancel state’s minor i ty shares in enterprises Sell or liquidate companies with majority state ownership Sell state shares in shipyards Sell or liquidate agro-kombinats Reduce state subsidies to enterprises Contain enterprise arrears Reduce administrative and regulatory barriers to business Rationalize the court system Reduce case backlogs and accelerate court proceedings Strengthen enforcement o f judgments, contracts, property rights, and bankruptcy procedures Reform employment legislation and rationalize the reward system Rationalize organizational structures Strengthen the policy process Improve internal audit and financial control Strengthen public procurement Improve efficiency and reduce drug and hospital expenditures Consolidate and improve targeting o f cash social benefits Adopt fiscally and socially sustainable pension indexation formula

Improving fiscal performance o f railways 0 Reduce the railway fiscal deficit

C. Overall Assessment o f Progress in Implementing PAL Reforms since PALl

52. The Government has made satisfactory progress in implementing the P A L program and al l PAL2 prior actions for the first tranche have been completed. A second floating tranche was introduced to PAL2 at the request o f the Croatian authorities to give them further time to complete three PAL2 actions, which could not be completed by end April 2007 but were considered important for the program goals. These actions are as follows: (i) complete the sale o f three HZ subsidiaries; (ii) sell majority shares in one shipyard; and (iii) enact the new Civ i l Service Salary Law and a new job classification system. Postponing the PAL2 Board was not an option, since the Croatian Parliament wil l be in recess after July 15, 2007 for the fall owing to forthcoming Parliamentary elections scheduled for November 2007. The three second trance actions are expected to be completed in 2007: three HZ subsidiaries sold and two further subsidiaries tendered; the new Civil Service Salary Law and job classification system enacted; and the majority shares in a shipyard sold.

53. PAL2 has in total 11 prior actions-eight for the f i rst tranche and three for the second tranche- compared to the nine actions anticipated in the P A L l Board documentation. The introduction o f the second tranche explains the slightly increased number. Table 2 l is ts the anticipated PAL2 prior actions12 in P A L l Board documentation and final PAL2 prior actions. The anticipated actions have remained essentially unchanged, except for some rewording and refocusing o f the public administration prior

Tr iggers are ca l led ant ic ipated prior actions. 12

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action, expansion o f the prior action on privatization to cover the sale o f three major loss-makers, and adjustment o f the prior action on health financing. The new Health Insurance Act enacted fell short o f the initial goal. Hence, to achieve the goal, Croatian authorities took a series o f further actions agreed half a year prior to appraisal with an overall revenuehavings target, which are listed as part o f the final actual PAL2 prior action. All these actions have been completed.

Box 2. Application of Good Practice Principles on Conditionality in PAL Principle 1: Reinforce Ownership The P A L supported reform program i s in line with the Government’s Strategic Development Framework and the Pre-Accession Economic Program, which lay out Croatia’s comprehensive economic policy. The latter document refers several times to P A L as the vehicle under which select reforms are to be carried out.

Principle 2: Agree up front with the government and otherfinancial partners on a coordinated accountability framework At the start o f the P A L series, a pol icy matrix outlining actions over the medium-term with clear and measurable overall and component specific outcome goals was developed joint ly with the Croatian government, and thereafter joint ly adjusted as the program has evolved. The reform program was also coordinated with other development partners (EC, IMF, EBRD, USAID, SIDA, UNDP, DfID, Netherlands), and a number o f them (SIDA, UNDP, USAID, DfID) have financed some o f the required technical assistance.

Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances The reform program i s based o n and part o f Government’s strategies and programs. I t reflects the intensive structural and institutional reforms needed across sectors for successful EU integration, and to complete the country’s transition to a well-functioning market economy. A t the start o f each operation in the series, the Council o f Ministers has reviewed and endorsed the reform program. Further, the program focuses on outcome- oriented actions, since that i s the best way to calibrate the series o f reforms that are necessary to achieve program objectives.

Principle 4: Choose only actions critical for achieving results as conditions for disbursement The P A L program focuses o n actions that are critical in terms o f achieving the set outcome goals, and the Government would have difficulties moving forward without external support. The number o f prior actions has been limited to six for P A L l , and eight for the first tranche and three for the second tranche o f PAL2.

Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support Progress made with the implementation o f reforms and achievement o f outcome goals i s monitored on a regular basis: a progress matrix, which outlines the status o f reforms and outcome indicators, i s updated periodically and circulated among ministr ies and agencies.

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D. Overall Progress Achieving Outcome Goals since PAL1

54. outcome goals as follows:

Progress towards overall PAL outcome goals: Croatia has made progress towards the three

General government expenditure has been reduced from 5 1.3 percent o f GDP in 2003 to 48.4 percent in 2006. The fiscal deficit has declined from 6.4 percent o f GDP in 2003 to 3.1 percent o f GDP in 2006.

The Doing Business 2006 report indicates an improvement in the investment climate.

According to EBRD reports, the private sector share in GDP has remained at 60 percent in 2005. This may be due to lack o f a private sector response to the improved investment climate, but also reflect the fact that the impact o f some reforms i s likely to be seen only wi th a lag. Indeed, some other indicators (such as private investment and private sector employment) suggest that the private sector has started to respond. National accounts data suggests that the private sector share in GDP rose to 69 percent in 2006.

55. In light o f the overall outcome goals being stretch goals, the reduction in total public spending by about 3 percentage points o f GDP and the over 3 percentage points o f GDP decline in the fiscal deficit are notable. However, from the macroeconomic point o f view, further fiscal consolidation i s still required and the authorities are targeting a fiscal deficit o f 2.8 percent o f GDP in 2007 and 2.6 percent in 2008 and a reduction in total public spending to 47.7 percent o f GDP in 2007 and further to 46.7 percent in 2008.

56. Progress towards sector/area outcome goals: In each o f the program's sub-components, the authorities have made steady progress towards the sectodarea specific outcome goals. In some areas, the set stretch goals for the end o f the program (that is, at the end o f PAL3) have already been achieved or are close to being met. Since many reforms supported by P A L are politically sensitive, progress made i s noteworthy. Examples o f the progress since the launch o f the P A L series are as follows:

State shares sold or liquidated in 841 companies;

Enterprise subsidies reduced as planned by over one percentage point o f GDP;

The court case backlog reduced by 30 percent, and indicators o f judicial performance show improvement;

The public sector wage bill reduced by about one percentage point o f GDP, legislation governing the civil service modernized, and including clauses to depoliticize state administration after the upcoming parliamentary elections;

Total public health spending reduced by close to 1.5 percentage points o f GDP, though the health sector arrears remain ~ ign i f icant ; '~

Pension spending on a steady downward trend;

The working ratio o f Croatian railways down by over 50 percentage points, and state aid to railways decreased by 0.7 percentage points o f GDP.

Since Croatia follows accrual accounting, actual spending includes the arrears. 13

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57. At the same time, however, there i s a significant r isk that some o f the progress achieved in the area o f social benefit spending-in terms o f consolidating the spending and increasing the share o f the best-targeted benefits to the poor and vulnerable-may be reversed in 2007, despite the PAL2 prior action having been met. The Government adopted in September 2006 a National Population Policy (NPP), which, if implemented as proposed, increases rather than consolidates social benefit spending in 2007. In net terms, the implementation o f this policy increases total social benefits spending by about 0.2 percent o f GDP in 2007 and, unfortunately, may decrease the share o f best targeted benefits. Since the Croatian authorities have capped social benefit spending at 4.0 percent o f GDP in 2007, this means that only part o f fiscal consolidation achieved in the area o f social benefits may be eroded. Also, the authorities expect further reductions in social benefit spending after 2007 as a result o f the implementation o f the social benefit spending reform strategy supported by PAL2.

58. Anticipated PAL3 Prior Actions: Looking forward, PAL3 i s proposed to focus on reforms that are critical for further fiscal consolidation in order to mitigate the r isks on the macroeconomic front, as well as for the achievement o f PAL outcome targets. In addition to satisfactory overall progress in meeting the program goals, Board presentation o f PAL3 i s proposed to be triggered, among others, by the following:

Croatian Privatization Fund sells (through tender or auctions) or liquidates the remaining companies with majority state ownership in a manner acceptable to the Bank.

Ministry o f Finance reduces enterprise subsidies to 2.2 percent o f GDP in 2007, and further to 2.0 percent o f GDP in the 2008 budget.

Consistent with the social benefit spending reform strategy, benefits consolidated and total social benefit spending reduced to 3.7 percent o f GDP in 2008.

Means-testing applied to health co-payment exemptions for social categories .of insurees.

HZ takes actions required to reduce the working ratio to 170 percent in 2007 and further to 150 percent in 2008.

CPF privatizes at least 7 further HZ subsidiaries.

E. Pillar I: Improving Investment Climate

59. Croatia’s performance in terms o f enterprise restructuring, privatization, new business development, attraction o f foreign direct investment, and creation o f an enabling investment climate has improved since the launch o f the P A L series. While, as noted earlier, the private sector share o f GDP i s still relatively l o w compared to a number o f other transition or EU countries, enterprise privatization, which i s needed to create space for the private sector, has been re-launched, state aid to enterprises has been gradually decreased since 2005, and the cost o f doing business has declined. This can be expected to affect positively the entry o f new business.

Privatization and Liquidation o f Stateowned Enterprises

60. Outcome Goal: State shares in at least 1,000 enterprises privatized or liquidated by end 2007.

Progress towards the goal: State shares privatized or liquidated in 841 enterprises (1 16 companies with majority state ownership and minority stakes in 725 companies)

17

61. P A L has supported the re-launch o f the privatization process in line with the Government’s Strategic Development Frarnew~rk ’~, and noteworthy progress has been made on this front: since the P A L launch in 2004, state shares have been privatized or liquidated in 841 enterprises.” This includes the sale o f all the remaining ago-kombinats, except one; most tourism companies; and two steel mills and an aluminum plant, which were large loss-makers. In addition, the privatization process o f one shipyard has started, and i t s majority shares are expected to be sold in 2007. Since the Government i s in the process o f preparing a National Shipyard Restructuring Plan for the EC’s approval, no further shipyards are expected to be sold in 2007. To prevent Government bailouts o f privatized companies, previous repurchase clauses have been excluded from these privatization contracts.

62. In 2006, the Croatian authorities were also drafting a new privatization law to govern privatization o f the remaining state-owned enterprises in the Croatian hva t iza t ion Fund (CPF) portfolio. The main objective o f the new law was to introduce an Employee Share Ownership (ESOP) model, but the model as proposed would have deviated from the international ESOP practice and i t s implementation might have created a category o f enterprises that have difficulties attracting strategic investors. Consequently, in spring 2007, the authorities decided to forgo the adoption o f the new law and retain the legal framework governing privatization unchanged at least through the Parliamentary elections scheduled for November 2007.

63. to privatization and liquidation o f state-owned enterprises:

Reform Strategy to Reach the Outcome Goal: PAL has supported the following actions related

Sell or cancel government’s minority shares in enterprises: o

o

Progress under PALI: CPF sold or cancelled state’s minority shares in 200 companies through the stock exchange. Progress under PALZ: CPF has sold or cancelled minority shares in 525 companies. Under PAL3, the remaining minority shares are expected to be sold.

Progress under PALI: CPF sold through tender or auctions ten companies with majority state ownership. Progress under PALZ: CPF has sold 31 and liquidated another 75 companies with majority state ownership. Under PAL3, the remaining companies with majority state shares are expected to be sold or liquidated.

Sell state shares in shipyards: Progress under PALI: CPF initiated preparation for the sale o f state shares in one shipyard.

Sell or liquidate companies with majority state ownership: o

o

o

P A L i s supporting the second round o f privatization to complete Croatia’s transition process. The f i rs t phase was carried out in early 1990s and was characterized by sales to managers and employees, and distribution to political supporters. I t did not provide the hoped-for boost to investment and growth, since companies were not transferred to those who could operate them most efficiently, and because the Government, instead o f establishing hard budget constraints and pushing the chronic loss-makers into liquidation, kept bailing out the newly privatized enterprises. l5 At the start o f the P A L series in 2004, there were about 1,132 enterprises wi th some form o f state ownership in the Croatia Privatization Fund portfolio. These consisted of: (i) 827 enterprises with state ownership o f 0-25 percent; (ii) 143 enterprises with state ownership o f 25-50 percent; and (iii) about 162 enterprises w i th more than 50 percent state ownership. Enterprises wi th high state ownership were mamly in shipbuilding, tourism, agriculture (agro- kombinats), and metal-processing sectors, and many o f them were loss-making, heavily indebted, and could not survive without direct subsidies (including for working capital).

14

18

o Progress under PAL2: The process o f privatizing majority shares in one shipyard has been initiated, with the sale expected in 2007. Under PAL3, a tender for another shipyard i s expected to be issued.

Sell or liquidate agro-kombinats: o Progress under PALI: Owing to concerns about the process o f agro-kombinat

privatization, the Ministry o f Agriculture (MoAFWM) prepared a strategy for enhancing competitiveness in the agricultural and food sectors, including the privatization o f agro- kombinats. Ten agro-kombinats were sold.

o Progress under PAL2: M o A F W M has implemented the strategy related to ago-kombinat privatization, and tendered the remaining agro-kombinat.

Improving Financial Discipline o f Enterprises

64. percent o f GDP in 2007; (ii) Reduced public enterprise arrears.

Outcome Goals: (i) Subsidies to enterprises reduced from 3.4 percent o f GDP in 2003 to 2.2

Progress towards the goals: (i) Enterprise subsidies reduced to 2.33 percent o f GDP in 2006 and to 2.2 percent o f GDP in the 2007 budget; (ii) Public enterprise arrears reduced from HRK1.36 bi l l ion at end 2004 to HRK486 mi l l ion in December 2006.

65. For the current round o f privatization to be successful, i t i s critical that the Government imposes hard budget constraints on privatized and other enterprises. The Government has supported the loss- making public and state-owned enterprises through generous subsidies, transfers, and guarantees. This i s costly to the economy, since supporting losses o f non-viable enterprises i s ultimately financed by taxes on the rest of the economy, involving resource transfers from eff ic ient to inefficient sectors, and constraining productive investments.

66. To bring the enterprise subsidies down to the average EU levels, the Croatian authorities have prepared and implemented the enterprise sector subsidy reduction plan16, and enterprise subsidies have been gradually but steadily reduced since the P A L launch.” Enterprise subsidies had increased significantly in Croatia in 2003 in the run-up to the last Parliamentary elections. In 2003, state aid to the enterprise sector18, including direct budgetary transfers and indirect financing through CPF, extra- budgetary funds, or the Croatian Bank for Reconstruction and Development (HBOR), amounted to about 3.4 percent o f GDP, compared to the EU15 average o f about 1.8 percent o f GDP. A large portion o f this aid went to shipyards, agro-kombinats, railways, and the metal and machinery manufacturing sector.

67. Also, the Government has been undertaking refoms to enhance the financial transparency o f key public sector enterprises and limit enterprise arrears. Public enterprise arrears stood at about 0.5 percent of GDP in 2004 as the PAL series was launched, and have since been reduced by 64 percent.

68. promote financial discipline o f enterprises:

Reform Strategy to Reach the Outcome Goals: PAL has supported the following actions to

l6 Judicial reforms supported under PAL are complementary to measures limiting state aid. In particular, the strengthening o f the bankruptcy procedures wil l help to ensure unhindered exit o f unviable enterprises.

The subsidy reduction p lan captures the subsidy elements in state issues guarantees. In parallel, the IMF supported SBA has imposed a cei l ing o n state guarantees.

Includes subsidies provided by central and local governments to public, privatized, and state-owned enterprises. 18

19

Reduce state subsidies to enterprises: o Progress under PALI: The Croatian authorities prepared an inventory o f direct and

indirect subsidies, and aligned their methodology with EU state aid guidelines. The Government also adopted a medium-term enterprise subsidy reduction plan that sets an overall annual ceiling to total subsidies, which i s tightened from one year to the next, and started i ts implementation. Enterprise subsidies were reduced from 3.4 percent o f GDP in 2003 to 3.0 o f GDP in 2004, and further to 2.72 percent o f GDP in the 2005 budget.’’ Progress under PAL2: Enterprise subsidies reduced to an actual 2.77 percent in 2005, and further to 2.33 percent o f GDP in 2006 and 2.2 percent o f GDP in the 2007 budget. Under PAL3, enterprise subsidies expected to be further reduced to 2.0 percent in 2008.

Progress under PALI: Quarterly publication o f public enterprises’ balance sheets, including liabilities and receivables data, commenced. Overdue payables and receivables of public enterprises reduced by 47 and 17 percent, respectively, from end-2004 to June 2005.

o Progress under PAL2: Overdue payables and receivables o f public enterprises reduced by 64 and 19 percent, respectively, from end 2004 to end 2006. Government arrears to public enterprises have declined by 44 percent from end 2004 to end 2006. Further reductions are expected under PAL3.

o

Contain public enterprise arrears: o

Reducing the Cost of Doing Business

69. GDP by 2008.

Outcome Goal: Private sector investment (including changes in stocks) increased to 25 percent o f

Progress towards the goal: Private sector investment increased to 26 percent o f GDP in 2005 and to 27.5 percent o f GDP in 2006. In 2007, private sector investment projected to reach 28.2 percent o f GDP.

70. In addition to completing the privatization process and ensuring that enterprises are subjected to the market discipline and exit mechanisms function, the Government needs to create an environment that facilitates new business entry. The analysis indicates that new private f i rms are most productive and generate most new employment in Croatia.

7 1. The Croatian Government has tackled a number o f administrative barriers to business since the launch o f the PAL series, and the recent Doing Business and other assessments indicate that the investment climate has indeed improved. Among other things, the Government has established one-stop shops to simplify business startup. Also, preparations are at an advanced stage for the introduction of a regulatory impact assessment and a regulatory guillotine, which aims to cut redundant and business unfriendly regulations by 40 percent by end-July 2007. These efforts have been supported USAID and FIAS. Further, the Bank supported Science and Technology Project has been covering a set o f measures in the area o f research and development (R&D). This includes strengthening and restructuring o f select R&D institutions, promoting commercialization o f research outputs, and providing funding for programs aimed at upgrading technological capabilities o f enterprises.

At the start o f the enterprise subsidy reduction plan implementation, Croatian authorities were concerned that the plan would block further privatizations by l imit ing privatization related liability write-offs. To address this concern, i t was agreed that in the context o f the subsidy reduction plan, the one-time privatization related write-offs could be offset by the revenues from privatization o f those companies.

19

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72. reduce the cost o f doing business:

Reform Strategy to Reach the Outcome Goal: P A L has supported the following actions to

Reduce administrative and regulatory barriers to business: o Progress under PALl: Amendments made to the Physical Planning and Construction

laws as well as to the Utility Services Law in 2004 to streamline the administrative procedures to obtain construction-related permits.

o Progress under PAL2: A new unified draft law on spatial planning and construction was completed in April 2007. Under PAL3, this law and the regulatory guillotine will be implemented.

Strengthening the Judiciary

73. o f the judicial sector showing progress in adapting to EU standards.

Outcome Goals: (i) 50 percent reduction in the court case backlog by 2008; (ii) EU assessment

Progress towards the goals: (i) the court case backlog reduced by 30 percent between April 2004 and November 2006 (from 1.64 to 1.15 mil l ion cases); (ii) EU assessment o f the judicial sector shows progress, but the large case backlog and ensuring proper enforcement o f judgments remain challenges.

74. The creation o f stable, clear, effective, and predictable laws and legal institutions i s one o f the main challenges facing Croatia in i ts efforts to promote investment and growth. For businesses to be successful, contracts and property rights need to be observed and protected, and the court system needs to provide impartial and efficient adjudication o f disputes. Strengthening the judiciary i s also critical for EU accession, and the Government considers it one o f the priority areas for reform.

75. The Croatian authorities have implemented a series o f reforms in the past couple o f years to improve the efficiency o f the judiciary and reduce the court case backlog, which was well above 1.5 mil l ion as the P A L series was launched. One o f the key sources o f inefficiency and backlog both in commercial and municipal courts was the non-adjudicative functions that judges were tasked with-such as land registration2' and titling, maintenance o f the company registry, execution o f judgments, supervision o f elections, and other administrative tasks.21 These tasks have now been almost completely been transferred from judges to other bodies.22 Also, the automated court case management has been brought to the point o f implementation, which should further help since i t s absence was contributing to inefficiency and backlogs.

76. The impact o f these measures i s already evident, and the case backlog has been rapidly declining. While the overall case backlog has declined by 30 percent, land registration and enforcement case backlogs were reduced by 50 and 15 percent, respectively, by September 2006. In parallel, plans for rationalization o f the court system have been prepared, since distribution o f work among the courts continues to be highly uneven, and the number o f county courts (21) i s high for the size o f the population. Bankruptcy procedures have also been streamlined to facilitate the exit o f unviable enterprises, and a movable property registry established.

Land registration cases alone formed about 50-60 percent o f the backlog. The backlog has not been caused by a shortage o f judges: the number o f judges per 10,000 inhabitants in Croatia

i s among the highest in Europe, but the number o f court supporting personnel per judge i s one o f the lowest. 22 Some Supreme Court judges, including the Supreme Court President, w i l l s t i l l participate in the supervision o f elections.

20

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77. strengthen the judiciary:

Reform Strategy to Reach the Outcome Goals: PAL has supported the fol lowing actions to

Rationalize the court system: o Progress under PALI: T o ensure a more even caseload distribution among courts, the

Government prepared and approved in June 2005 a strategy and an action plan for the reform o f the judicial system.

The Government decided to proceed with rationalization in phases. The rationalization process has started with mergers o f f ive misdemeanor and five municipal courts o n a p i lo t basis. Under PAL3, the rationalization o f courts i s expected to proceed o n a broader scale.

Reduce case backlogs and accelerate court proceedings: o Progress under PALI: Land registration was transferred f rom judges to court clerks in

municipal courts. Also, the Ministry o f Justice adopted an IT strategy for courts. o Progress under PAL2: Other non-adjudicative functions--commercial registries,

enforcement o f court decision, and partially participation in electoral commissions-have been transferred f rom judges to other judic ia l personnel or outside o f courts, and new caseload and workload rates per judge have been adopted. Also, the Court Rules o f Procedure have been modif ied to support the automated court management system.23

Strengthen enforcement of judgments, contracts, property rights, and bankruptcy

Progress under PALI: To facilitate enforcement and execution o f contracts and property rights, the L a w o n Execution was amended. Progress under PAL2: T o reduce average duration o f a bankruptcy case, the bankruptcy l a w has been amended, and the regulatory framework for bankruptcy trustees (certification exam, maintenance o f the l i s t o n bankruptcy trustees) developed. A movable property registry has been established, and under P A L 3 it i s expected to be fully functioning .

o Progress under PAL2:

procedures: o

o

F. Pillar 11: Strengthening Governance

78. Public administration and public expenditure management have also been strengthened in the past couple o f years, and improvement o f expenditure management i s notable. A prerequisite for effective pol icy implementation and public service delivery i s efficient, skilled, and motivated public service. The emphasis in PAL has been o n measures that reduce the size and promote effectiveness o f publ ic administration, and enhance the efficiency o f public expenditure management. Wh i le the public sector wage bill has declined since the launch o f the PAL series, i t i s s t i l l high by international standards, and would need to be further pruned in the quest to reduce the size o f the state. Also, since adequate public administration capacity i s one o f the key requirements for EU accession, further reforming and modernizing public administration i s critical.

Development o f information technology and capacity for the introduction o f the automated case management 23

system i s supported in parallel by the Court and Bankruptcy Administration Project.

22

Strengjhening Public Administration

79. Outcome Goals: (i) reduction in the publ ic sector wage bill f i o m about 11 percent o f GDP in 2003 to 10 percent o f GDP in 2008; (ii) EU assessment o f public administration showing progress in adapting to EU standards; (iii) public administration depoliticized by 2008.

Progress towards the goals; (i) Public sector wage bill reduced to 10.1 percent o f GDP in 2005, and to 9.9 percent o f GDP in 2006; 24 (ii) EU assessment o f publ ic administration indicates l imi ted progress, legislative changes remaining to be implemented and enforced; (iii) A new C i v i l Service L a w enacted, but i ts depoliticization clauses become effective only

80. Since the launch o f the PAL series, the public sector wage bill has been reduced, and the outcome goal regarding the wage bill already achieved. However, further measures to strengthen and modernize public administration are st i l l needed. In particular, the recent legislative changes would s t i l l need to be rigorously implemented and enforced.

‘ after Parliamentary elections in 2007.

8 1. To realign the size and role o f the state as we l l as to strengthen the pol icy making process and service delivery, the authorities have taken a number o f measures regarding the size, structure, and remuneration of the public service. T o address the size and structure, the Government has launched a rationalization effort”, starting with the Ministry o f Health and Social Welfare and two state administration offices at the county level. These entities have prepared rationalization plans consistent with the recommendations o f pr ior functional reviews. Functional reviews o f other ministries and county offices are being carried out. The Ministry o f Finance has in parallel proceeded with the development and pi lot ing o f a government-wide personnel and payrol l database to help control the size o f public administration and wage bill.

82. T o modernize the c i v i l and public service consistent with EU standards, a n e w Civil Service L a w has been enacted and a L a w o n C iv i l Service Salaries i s expected to be enacted by September 2007. The new Civil Service Law, among other things, requires depoliticization and professionalization o f the top level o f state administration and, specifically, reintegration of Assistant Ministers and Ministerial Secretaries in to the c i v i l service system to ensure continuity in pol icy and management. Wh i le the depoliticization clauses become effective only after next Parliamentary elections, a series o f other laws have in the meantime been amended to reflect depoliticization in order to reduce the r i s k o f non- implementation. The j o b classification system i s also being revised to ensure similar jobs across ministries and agencies are consistently classified. Further, the new L a w on Civil Service Salaries, which i s being finalized, includes provisions for decompression and performance-based remuneration.26 The current reward system i s fragmented and too compressed to provide performance incentives to staff. It also poses issues o n equity, and impedes the development o f an integrated public administration system.27 The new L a w on C iv i l Service Salaries i s expected to be later l inked to a future legislation covering the broader public sector.

24 Based o n the consolidated general government statistics. 25 In addition, the Government reduced the number o f ministries, and rationalized some administrative units placed directly under the Government in 2004.

The implementation o f the Civil Service Salary L a w i s supported by over dozen decrees and other secondary legislation, w h i c h introduce modern human resources management in public administration.

F o r example, different organizations within the c i v i l service had varying pay levels for similar jobs, and local authorities were seen as being paid excessive salaries compared to other publ ic sector staff.

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83. The policy process has also been strengthened. Weaknesses in the policy formulation process led earlier to the adoption o f policies with adverse fiscal, social, environmental, or state aidcompetition impacts. With the support o f PAL, the Rules o f Procedure o f the Government have been amended to require assessment o f fiscal, state aidcompetition, social and environmental impacts o f policy proposals, and a satisfactory response to the comments o f the Office for Legislation on the legal compatibility o f draft laws.

84. strengthen public administration:

Reform Strategy to Reach the Outcome Goals: PAL has supported the following actions to

0 Reform employment legislation and rationalize the reward system: o Progress under PALI: The new Civ i l Service Law enacted, which provides incentives

for depoliticized, efficient, client-oriented, and performance-based administration. However, the depoliticization clauses will become effective only after the next Parliamentary elections. Progress under PAL2: The forthcoming depoliticization o f public administration has been further reinforced in a set o f technical amendments to the laws on Government Officials, System o f State Administration, Transfer o f Power, and Conflict o f Interest. To unify and decompress civil service salary structures, a new Law on Civ i l Service Salaries and a new job classification system are being prepared and expected to be enacted by Parliament by September 2007. Under PAL3, new legislation on public employment conditions, including provisions for centralized collective bargaining, i s expected to be adopted.

Progress under PALI: The Government developed and endorsed a functional review methodology to assess current organizational structures, and functional review pilots were conducted in two central ministries and two county offices.

The Ministry o f Health and Social Welfare and two state administration offices at the county level have prepared rationalization programs based on the functional review results. Also, the Ministry o f Finance has developed a personnel and payroll database with an interface to the Treasury system to improve the control o f the public administration size and the wage bill. The system i s piloted in selected ministries, and the plan i s to develop a full human resource management information system under PAL3. Also under PAL3, all the remaining min is t ies and county offices are expected to adopt rationalization programs.

Progress under PALI: To increase quality and fiscal affordability o f proposed laws and policies, the Rules o f Procedure o f Government were amended to make impact assessment (fiscal, social, environmental, and state aidcompetition) o f proposed policies and legislation mandatory. A standard methodology for fiscal impact assessment was adopted and i t s implementation started.

o Progress under PAL2: Fiscal and state aidcompetition impact assessment has been conducted as agreed on all proposed policies and legislation submitted to Parliament. Methodologies for social and environmental impact assessment have been prepared, and their implementation started at the beginning o f 2007.

o

Rationalize organizational structures: o

o Progress under PAL2:

Strengthen the policy process: o

Improving Public Expenditure Management

85. Outcome Goal: General Government spending consistent with the medium-term fiscal framework.

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Progress towards the goal: General government spending reduced f rom 5 1.3 percent o f GDP in 2003 to 49.3 percent o f GDP in 2005 and further to 48.4 percent o f GDP in 2006.

86. Since the PAL launch in 2004, the Croatian authorities have made significant progress in strengthening publ ic expenditure management.** The budget execution processes, including accounting and reporting structures, have improved. GFS 2001 standards have been formally adopted in accounting and reporting, although adherence to these standards by some local governments remains questionable. The Treasury Single Account has been expanded to cover bank accounts o f a l l l ine ministries and the remaining extra-budgetary funds (health insurance find, pension find, employment fund). Also, the Ministry o f Finance has carried out a l l the preparatory w o r k to integrate existing financial management information systems in 2007. Whi le the Government has made progress in controlling arrears, they st i l l exist (for example in the health sector). The strengthening o f financial management processes can be expected to reduce them over time.

87. Further, the authorities have, with the help of EC, established internal audit units in a l l l ine ministries, central state organizations, and extra-budgetary funds. Their establishment i s also underway in local governments. Internal auditors have been fully trained, and measures to enhance the quality o f audits are being undertaken. The L a w o n Financial Management and Control Systems in the Public Sector has been enacted, controllers have been appointed to l ine ministries, and a financial management control manual i s being prepared

Internal control has also been strengthened.

88. improve public expenditure management:

Reform Strategy to Reach the Outcome Goal: PAL has supported the fol lowing actions to

Improve internal audit andfinancial control: o Progress under PALI: The internal audit and control function was strengthened through

the establishment o f internal audit units in over h a l f o f the l ine ministries and the c i ty o f Zagreb. Also, the Ministry o f Finance developed, issued, and disseminated a rule book, standards, and manual for internal audit, including certification requirements for internal auditors. Progress under PAL2: All 13 l ine ministries, extra-budgetary funds, nine central state institutions and some local government units have established internal audit units, and their establishment i s some large cities and counties. Under PAL3, the remaining large cities and local governments are expected to establish such units.

o

28 At the start o f the PAL series, the Bank and IMF agreed o n a division labor in the area o f publ ic expenditure management. Since the IMF under S B A focused o n strengthening o f budget formulation and debt management, these areas were no t included into the PAL program, but PAL focused o n internal audit and budget execution. The Bank has, however, supported reforms o n the debt management and budget planning through an IDF grant, as has the EC. Debt management has also been strengthened in the past couple o f years: a new public debt management and recording system as w e l l as an electronic system for treasury bill auction have been introduced and staff trained; the department in the M in i s t r y o f Finance covering debt management has been reorganized with separate front (debt issuance), middle (risk management) and back (debt recording, planning and analysis) offices; and a new publ ic debt management strategy has been adopted. The budget formulation has also improved. A m o n g other things, the Government has shifted to a three-year budget framework. In 2006, publ ic finance statistics were for the first t ime constructed according to E S A 95, by using the transfer tables between the national chart o f accounts and E S A 95 methodology, wh ich wil l enable the cross-country comparison o f the publ ic finance statistics. Further, the state budget coverage has been expanded f r o m the 2006 budget onwards by inclusion o f lottery revenues, road charges, own revenues o f budgetary users, revenues under the special regulations (administrative taxes and other earmarked revenues), and EU grants. The control o f collection and the use o f earmarked revenues have also been established.

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Improve budget execution: o Progress under PALI: The Ministry o f Finance carried out an assessment o f functionality

and overlap o f financial management information systems (including S A P ) operating in ministries and other budget entities.

o Progress under PAL2: Based on the assessment results, the Ministry o f Finance has prepared a strategy and operational guidelines to rationalize and integrate the financial management information systems. The integration o f system i s taking place in 2007. Further, to improve budget execution, the Treasury Single Account coverage has been widened to cover and consolidate bank accounts o f al l line ministries and extra-budgetary funds into it.

Strengthen public procurement: The authorities are in the process o f harmonizing the public procurement legislation with EU requirements. Under PAL3, a new Public Procurement Law, consistent with EU Directives, i s expected to be enacted.

G. Pillar 111: Enhancing Fiscal Sustainability of Sector Programs

89. The level and efficiency o f social sector spending requires attention in the quest to reduce the size o f the state, enhanced macroeconomic stability, and higher growth. Public spending on health and pension has declined since the P A L launch, but social benefit spending continues to be high by international standards. The financial performance o f the Croatian Railways (HZ) has significantly improved, but it remains one o f the worst performing railways companies in Europe, and the current level o f subsidies required for its operation i s s t i l l high.

Health Financing

90. percent o f GDP in 2008; (ii) arrears in health sector cleared.

Outcome Goals: (i) total public health spending reduced fi-om 7.7 percent o f GDP in 2003 to 6.0

Progress towards the goals: (i) total public spending on health reduced to 6.1 percent o f GDP in 2005, and to 6.0 percent o f GDP in 2006; (ii) health sector arrears increased from HRK743.8 mil l ion at end September 2004 to HRK1.27 bi l l ion at end 2006.

91. W h i l e public spending on health has declined notably since the P A L launch, health sector arrears have increased and continue to be ~izeable.~’ This i s a concern, which both the P A L program and the IMF SBA have attempted to address. To further reform the health sector and control the growth o f arrears, changes in the demand for and supply o f care as well as improved accountability mechanisms are required. P A L has supported interventions which attempt to reduce unnecessary demand for health services.

92. As the first step o f health financing reform, the Government introduced a small administrative fee for health services in the summer 2005. In 2006, as the second step, the Parliament enacted a new Obligatory Health Insurance Act, which reduced health co-payment exemptions and cut the drug co- payment coverage under the complementary health insurance. In Croatia, about 60 percent o f the population has been exempted f iom health co-payments (2.4 mi l l ion people costing about HRK800 mil l ion per year), not just the poor and vulnerable as i s the case as in EU countries. In principle the exemption policy i s based on poverty, but the practice i s different since most exemptions are categorical and parts o f them income-tested, instead o f means-tested, and thus not necessarily targeted to the poor

Since Croatia i s following accrual accounting, the arrears are included in the actual spending figures. 29

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and vulnerable. The new l a w has strengthened income-testing o f co-payment exemptions (by adjusting fami ly and income definitions) as the first phase toward gradual extension o f means-testing to determine co-payment exemptions. In addition, the l i s t o f unemployed people eligible for health co-payment exemption has been updated and made consistent with the data o f the unemployment r e g i ~ t r y . ~ '

93. Further, t o control spending o n drugs, the new l a w has introduced two drug lists: a l is t for essential drugs not requiring co-payments (that is, covered by the Obligatory Heal th Insurance), and an additional l i s t requiring co-payments. The coverage o f these drug co-payments has been eliminated f rom the complementary health insurance. The Croatian Health Insurance Fund (HZOZO) has also revisited and revised the drug l i s t since i t s issuance to ensure that the target savings/revenues (HRK400-500 m i l l i odper year) are achieved. HZOZO will hereafter adjust the l is t on an annual basis to guarantee the savingshevenues.

94. However, the new l a w did neither rationalize the basic package no r shift the complementary insurance to the private sector3' as in i t ia l ly expected. Instead, the authorities have implemented a series o f supply side measures to improve cost control in hospitals. Also, the authorities have committed to strengthen the collection o f the administrative fee, and to take action if the revenues collected fa l l short o f the HRK320 m i l l i on annual targets. Whi le the second stage reform was less extensive than desired, the estimated fiscal savingdrevenues f rom a l l the above mentioned reforms will be close to HRKl billion per year.

95. T o strengthen cost control in hospitals, the authorities have launched the reform o f the payment mechanism for hospitals with the introduction o f Diagnostic Related Groups (DRGs). Rather than paying hospitals based on inputs, under the new system hospitals will be paid the average treatment cost o f a case (with similar diagnoses and corriplicating factors). This payment system i s expected to improve the allocation o f financing, reduce disparities, and create incentives for hospitals to reduce the average length o f hospital stays, conform to cost norms, and control spending. I t may, however, also create incentives for treating increased number o f cases. A parallel strengthening o f HZOZO's monitoring capacity and enforcement o f budget ceilings wil l thus be essential. The Government i s also planning to restructure the supply o f health care services, with the a im to increase the share o f health care funding going to patient care and reduce the share on administration. As the f i rs t step o f reform, accreditations rules have been issued that classify hospitals according to the services they can provide. The a im i s t o increase the application o f cost-effective care solutions, such as day-surgery, and long-term care solutions, and to reduce acute care beds currently used for these services.

96. increase sustainability o f health sector financing:

Reform Strategy to Reach the Outcome Goals: PAL has supported the fol lowing actions to

Improve efficiency and reduce drug and hospital expenditures: o Progress under PALI: The Ministry o f Health and HZOZO prepared a pol icy proposal

on the (i) revision o f HZZO basic benefit package; (ii) reduction o f co-payment

About 100,000 employed people were o n the list o f unemployed eligible for health co-payment exemption, since the system relied on self-reporting. 3 1 To control the overuse o f health services, the 2002 Health Insurance L a w had introduced co-payments for select services in the basic health package. However, to increase HZOZO revenues, a voluntary complementary health insurance program was introduced at the same time to cover these co-payments. This re-introduced the moral hazard problem that co-payments were meant to mitigate in the f i rs t place. I t also increased administrative costs and introduced an adverse selection problem, since the complementary insurance was purchased by beneficiaries wi th hghest medical costs. Hence, to ensure the complementary insurance i s priced appropriately to reflect the cost o f its provision and excess demand controlled, shifting it to the private sector would be important.

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exemptions; and (iii) restructuring o f the complementary health insurance. To reduce drug and hospital expenditures, the time required for drug registration was reduced, the number o f generic drugs on the drug list was expanded, and contracts with limits on prescriptions were introduced.

o Progress under PAL2: A new Health Insurance Act, reducing co-payment exemptions and limiting the complementary health insurance coverage has been enacted. However, since the new Act only partially met the init ial policy goal, the Croatian authorities have undertaken following supplemental measures: (i) two l is ts o f drugs-and essential list not requiring co-payments, and an additional l i s t requiring co-payments-have been introduced with target savingshevenues o f HRK 400-500 milliodyear; (ii) income- testing of co-payment exemptions has been strengthened by adjusting the definition o f the family consistent with the definition o f the Center for Social Welfare, and by expanding the definition o f income in the Basic Health Insurance Law; (iii) HZOZO has updated the l i s t o f unemployed eligible for exemption on a monthly basis based on unemployment registry data; (iv) MoHSW and HZOZO have assessed the revenues generated by the administrative fee, and intend to strengthen existing control mechanisms for the collection o f fees to ensure target revenues continue to be achieved; (v) MoHSW has prepared draft accreditation legislation (vi) the DRG model has been piloted in four pilot hospitals, and an init ial evaluation and fiscal impact assessment o f the f i rs t few months o f implementation has been completed; and (vii) MoHSW has completed the f i rst phase o f the hospital master plan. Under PAL3, means-testing i s expected to be applied to health co-payment exemptions for social categories o f insurees.

,Reform of Social Benefits

97. Outcome Goal: Total spending on non-contributory social benefits reduced from 4.1 percent o f GDP in 2004 to 3.5 percent o f GDP in 2008, while the share o f the best-targeted and means-tested social support allowance increased.

Progress towards the goal: Total spending on social benefits reduced to 4.0 percent in 2005 and further to 3.8 percent o f GDP in 2006; while the share o f best-targeted (means-tested) benefits has remained stagnant at about 0.36 percent o f GDP in 2004-2006.

98. Total spending on social benefits has declined since 2004, albeit m ~ d e r a t e l y . ~ ~ At 3.8 percent o f GDP in 2006, total spending remains high compared to the EU average o f 2.5 percent o f GDP. The share o f spending on the best-targeted (means-tested) benefits has remained stagnant between 2004 and 2006, and the system s t i l l fails to protect the most vulnerable members o f the society, owing to the poor targeting and administration o f benefits.33

The PAL series has attempted to correct the early 2004 po l i cy reversal in t h s area. To al ign spending levels with comparable countries and cut the excess, many social benefits were reduced in 2001. At the beginning o f 2004, however, enhanced categorical benefit packages were reintroduced, including child, maternity, and war veteran benefits, along with exemptions f r o m taxes. As a result, total social benefit spending rose to 4.1 percent o f GDP in 2004, and spending o n less well-targeted benefits increased. 33 Only h a l f o f the total social benefit spending reaches the bo t tom quint i le o f population, and h a l f o f social assistance beneficiaries are able bodied unemployed.

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99. The Government has recently adopted a social benefit spending reform strategy, which aims to consolidate the over 100 existing social benefits34, strengthen their administration, and increase the share o f finds allocated to means-tested benefits to reduce poverty.35 The strategy will be implemented from 2007 onwards. However, the strategy focuses only on social welfare benefits, and most categorical benefits, which significantly increased in early 2004, are not covered.

100. In late 2006, the Government also adopted a National Population Policy (NPP), which aims to address Croatia’s adverse demographic trend and calls for, among other things, further increases in child, maternity, and family benefits which are already at EU15 levels. In net terms, the implementation o f this policy i s estimated to increase total social benefits spending by about 0.2 percent o f GDP in 2007, and, unfortunately, may decrease the share o f best targeted benefits. However, the Croatian authorities are committed to capping total social benefit spending at 4.0 percent o f GDP in 2007, and expect further reductions thereafter as a result o f the implementation o f the social benefit spending reform strategy mentioned above.

101. rationalize and target social benefits:

Reform Strategy to Reach the Outcome Goal: PAL has supported the following actions to

Consolidate and improve targeting of cash social benefits: o Progress under PALl: The Government established an inter-ministerial working group

to prepare a strategy for reform o f social benefit spending, with the aim to consolidate the benefits, reduce overall spending on social benefits and increase the share allocated to the means-tested benefits reaching the most disadvantaged. Progress under PALZ: The Government has adopted the strategy for social benefit reform, and started i t s implementation. Under PAL3, consistent wi th the strategy, benefits are expected to be consolidated, share o f means-tested benefits increased, and total social benefit spending reduced to 3.7 percent o f GDP.

o

Improving the Sustainability of the Pension System

102. Outcome Goal: Pension spending reduced fi-om about 12.3 percent o f GDP in 2004 to below 11.45 percent o f GDP in 2008.

Progress towards the goal: Pension spending reduced to 12.1 percent o f GDP in 2005 and to 1 1.9 percent o f GDP in 2006.

103. Pension spending has been declining as projected, and the 2004 reversal o f the pension indexation formula has been rectified. In March 2004, the Parliament had passed amendments to the Pension Insurance Act, which provided for a pension supplement and indexed pensions to nominal wages, thereby partly reversing the 1998 pension reform. That had both fiscal and structural impacts on the pension system, as pension expenditures as a share o f GDP, transition costs, and the primary pension deficit started to balloon. Faced with that prospect, Parliament turned in 2005 the pension indexation

In addition, local governments provide social assistance programs, which are financed from local and regional government budgets. These programs serve the same groups as national programs, resulting in duplication and misuse.

The analysis suggests that in principle l i f t ing al l people out o f poverty with perfect targeting o f assistance would require reallocation o f only about 0.7 percent o f GDP worth o f less well-targeted benefits to the means-tested ones.

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back to the Swiss formula36, which i s fiscally and socially sustainable. As a result, pension spending as a share o f GDP has returned to a downward trend.

104. The mode and pace o f repayment o f the debt to pensioners has also been settled. In July 2004, the Act on Implementation o f the Decision o f the Constitutional Court o f M a y 12, 1998 was passed stipulating that the Government needs to repay the so called “debt to pensioners” in relation to a Constitutional Court’s decision o f 199g3’. According to the law, the debt will be repaid by establishing a Pensioners’ Fund funded from existing Government-owned stocks and real estate. The size o f the debt was established by calculating the debt for each individual, and the repayment o f debt started in 2006.

105. Pressures for further pension reform have emerged as Parliamentary elections approach. However, the Croatian authorities have stated that there will be no further amendments to the pension insurance law during PAL.

106. enhance sustainability o f the pension system:

Reform Strategy to Reach the Outcome Goal: P A L i s supporting the following action to

Strengthen fiscal and social sustainability of the pension system: o Progress under PALI: The nominal wage indexation o f pensions was to be reversed and

replaced with a fiscally and socially sustainable pension indexation formula under PAL2. However, action was taken on this front earlier than anticipated. Shortly before the distribution o f PAL1 documents to the Board, the Parliament reversed the pension indexation back to the so called Swiss formula.

Improving Fiscal Sustainability o f the Railways

107. percent at end 2007.

Outcome Goal: The HZ worlung ratio38 reduced from 243 percent at end 2004 to 150-170

Progress towards the goal: The HZ working ratio declined to 190 percent at end 2006, and projected to reach 170 percent at end 2007.

108. Since the launch o f the P A L series, the Croatian Railways (HZ) has launched restructuring and there has been noteworthy improvement in HZ’s financial performance. The HZ working ratio has declined by over 50 percentage points, and state aid to HZ has decreased from about HRK 3.5 bi l l ion in 2004 (1.4 percent o f GDP) to about HRK2.1 bi l l ion in 2006 (0.8 percent o f GDP). The restructuring has focused on: (i) reduction o f labor costs through staff layoffs (about 1,100 staff retrenched in 2005-2006, about 600 additional staff to be retrenched in 2007);39 (ii) privatization o f subsidiary companies (four HZ subsidiaries tendered and to be sold by end June 2007); and (iii) reduction in services or discontinuation o f loss-malung local passenger services (a program to be adopted by the Government by end June 2007).

36 The Swiss formula i s a mean average of the average nominal gross wage and inflation indexes. 3’ The Law on Pension Increase to Eliminate Discrepancies in Pensions Acquired in Diferent Periods, which was enacted in 2001, permanently raised the pension expenditures by over one percent o f GDP, and consequently the replacement rate, to repay the debt. According to the Article 1 o f the law i t s execution satisfies the 1998 Constitutional Court Ruling. 38 The worlung ratio i s calculated by dividing operating costs (excluding depreciation) by operating revenues (excluding revenue from public service obligations and operating subsidy from the state budget-the exception i s ticket discount reimbursement f rom the city o f Zagreb, which i s included in the calculation). 39 HZ has s t i l l about 13,600 workers, while a railway the size o f HZ could be run with about 8,000 workers.

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109. However, the reform and restructuring o f HZ i s by no means complete, and substantial further reform i s s t i l l required to make HZ a financially viable company and able to withstand competition from other European railways. In 2006, HZ revenues just covered i ts labor costs, and the level o f HZ state aid was still significantly higher than the level o f railways state aid in EU and neighboring countries.

110. improve fiscal sustainability o f railways:

Reform Strategy to Reach the Outcome Goal: PAL has supported the following actions to

Reduce the railway fiscal deficit: o Progress under PALI: The Government adopted a medium-term business plan, and HZ

took actions to reduce the working ratio to 220 percent in 2005. These actions were as follows: (i) HZ laid-off through voluntary and involuntary retrenchment 534 staff from the mother company (staff retrenched was not rehired in the HZ mother company or subsidiaries as had been the case in the previous round o f restructuring, and HZ closed al l positions le f t vacant); (ii) staff to retire in the f i rs t six months o f 2005 left HZ as per the retirement schedule; (iii) HZ new hiring was kept within a total limit o f 80 new staff in 2005; (iv) HZ prepared a time-bound step-by-step plan for privatization o f subsidiaries in 2005-09, started i ts implementation; and the Government issued a decision on the legal framework governing HZ subsidiary privatization; and (v) HZ conducted further analysis to reduce services along or to close uneconomic lines in 2006-09. HZ salaries were also kept frozen. Progress under PAL2: HZ reduced the working ratio to 220 percent at end 2005, and further to 190 percent by end 2006. To reach the target, the following actions were taken: (i) HZ laid-off through voluntary and involuntary retrenchment 500 staff from the mother company (staff retrenched was not rehired in the HZ mother company or subsidiaries, and HZ closed all positions left vacant); (ii) 100 staff retired in 2006; (iii) new hiring was kept within a total o f 100 new staff limit for 2006; (iv) HZ staff salaries continued to be frozen at the 2005 level; and (v) MSTTD prepared and the Government approved a program to reduce services or close uneconomic lines in 2006-09. Further, to reach the working ratio target o f 170 percent at end 2007, HZ will reduce i t s staff in net terms by at least 530 staff through a retrenchment program, natural attrition, involuntary lay-offs, and limited new hiring. If part o f the redundant staff chooses to go to the HZ Foundation, the total number o f layoffs will be increased so that all the funds available for retrenchment are used in 2007. Otherwise, state budget financing for layoffs will be reduced accordingly. In addition, four HZ subsidiaries have been tendered. Their sales are expected to be completed and two further HZ subsidiaries tendered by end June 2007.

o

VI. OPERATION IMPLEMENTATION

A. Poverty and Social Impacts

1 1 1. Social impact assessment: Privatization o f shipyards may have distributional effects. Therefore, a social impact assessment o f shipyard restructuring plans proposed by shipyard management was conducted on two shipyards (Brodotrogr and Kraljevica) in 2006, and the results disseminated to Croatian authorities. The assessment involved a survey o f shipyard employees, subcontractors, and a control group o f non-shipyard employees. The results o f the assessment suggest that the social impacts o f shipyard restructuring are likely to be relatively modest as workers are more adaptable than had been expected. Shipyard employees expressed confidence that their sk i l ls would enable them to work in another sector; and a large share has prior experience in non-shipbuilding. There results also indicate that the majority o f those employed in shipbuilding do not consider it a desirable sector in which to work. There i s evidence o f a generational shift away from shipbuilding: the majority o f respondents did

31

not think their children will enter shipbuilding, nor did they want them to choose that profession. The Government i s in the process o f preparing a National Shipyard Restructuring Plan, including a plan for social mitigation measures. The results o f the social impact assessment have been taken into account by the authorities in i t s preparation.

112. Social consultations and mitigation measures: In the context o f a number o f other sectoral reforms (such as, health insurance, new privatization law, HZ, social benefit spending), a series o f consultations have been conducted with stakeholders on the proposed reforms. Social mitigation measures, such as severance packages in the case o f HZ, have been taken by the authorities as necessary.

113. Introduction of mandatory social impact assessment of new laws and policies: Further, a mandatory social impact assessment methodology has been prepared, and from 2007 onwards it wil l be applied to new policies and legislation. Prior to i t s completion, consultations on this methodology and the associated users’ guides were conducted by the authorities.

B. Fiduciary Aspects

1 14. Public Financial Management System: The Croatia Country Financial Accountability Assessment (CFAA) was carried out in early 2004 and finalized in May 2005. I t concluded that overall the central and local government financial management systems represent significant fiduciary r isk. In the areas o f treasury and cash management, accounting and financial reporting, internal control and internal audit, the fiduciary risk was considered significant, partly due to the existence o f many bank accounts o f budget users outside the single treasury account, delays in preparing the statutory consolidated state budget, and the existence o f multitude accounting systems, some o f which were outdated and did not meet the current standards for security and protection. Also, there were delays in issuing the rule books mentioned in the internal control legislation, and an internal control environment not capable to mitigate the risk o f corruption and conflict o f interest. Given the introduction o f program budgeting and the capacity o f the State Audit Office, the fiduciary risk was considered moderate in the fields o f budgeting, external audit, and parliamentary oversight. However, Croatian authorities have since carried out significant reforms to strengthen public expenditure management. The key recommendations o f CFAA in the areas o f budget execution and internal audit have been reflected in the reform program supported by PAL, and those reforms have been satisfactorily implemented (see the sub- section on public expenditure management, paragraphs 86-89). Also, the EC continues providing substantial technical assistance to build capacity for internal audit and control. Further, the EC and IMF as well as the Bank in the context o f an IDF grant have been supporting reforms in the areas o f debt management and budget formulation, and these functions have also been strengthened (see the footnote 24). A Needs Assessment o f Fiduciary Technical Assistance Harmonization was carried out joint ly wi th EC in April 2006. This study i s expected to facilitate better coordination and planning o f required technical assistance, including capacity to effectively utilize post accession grant EU funds.

115. The Country Procurement Assessment Report (CPAR) was finalized in March 2005, and rated at that time the level o f risk in public procurement as average. Since then, consistent wi th the CPAR recommendations, the institutional capacity o f the Public Procurement Office and the State Commission have been strengthened with assistance from the EC, and these entities have taken the lead in procurement reform in Croatia. The key procurement reform recommended-a new public procurement law (including standard tender documents and e-procurement provisions)-has been included into the P A L program. The new law, which has been developed with EC assistance and will be consistent with EU requirements, i s currently at an advanced stage o f preparation.

116. Safeguards Assessment of the Central Bank: The Report on the Observance o f Standards and Codes o f Fiscal Transparency, which was completed by the IMF in November 2004, concluded that the

32

Croatia National Bank (CNB) has operational independence and that i t s financial relationship with the Government i s transparent. CNB i s audited by independent auditors every year and the 2005 audit report has unqualified opinion.

117. The IMF conducted a safeguards assessment o f CNB in 2003, and concluded that the safeguards are adequate. An updated safeguards assessment o f CNB was finalized in August 2006. The assessment concludes that the CNB continues to maintain an effective system o f internal controls and nearly all areas o f the safeguards meet the policy’s requirements, though the internal audit mechanisms could be strengthened further. Based on the IMF’s assessment, CNB can be relied upon to account for the World Bank’s proceeds from development policy operations.

C. Disbursement and Audit

118. Disbursement: The loan o f E m 1 5 0 mil l ion (US197.4 mil l ion equivalent) would be disbursed in two tranches: EURlOO mi l l ion f i rst tranche, and EURSO mil l ion second tranche. The f i rst tranche would be made available upon Loan effectiveness, and the second tranche upon satisfactory completion o f second tranche conditions. The closing date o f the loan would be June 30, 2008. The proposed loan will follow the Bank’s disbursement procedures for development policy lending, and will be disbursed in compliance with the stipulated tranche release conditions. Disbursements will not be tied to any specific purchases and will be without procurement requirements. When the loan becomes effective, the IBRD will deposit the proceeds o f the loan into a deposit account at CNB, as designated by the government and acceptable to the Bank, and they form part o f the general reserves o f the country. N o dedicated deposit account wil l be required. Prior to that, the Bank wil l withdraw from the Loan Account a front-end fee amounting to one percent o f the principal amount, less any waivers. If, after depositing in this account, the proceeds o f the loan are used for ineligible purposes as defined in the Loan Agreement, the Bank will require the Borrower to refund the amount directly to the Bank.

1 19. Accounting and Auditing Arrangements: The administration and accounting o f the loan wil l be the responsibility o f the Ministry o f Finance. The standard country rules will be followed by treasury for administration and accounting. The government wil l maintain accounts and records, or ensure that such items are maintained, showing that loan disbursements were in accordance with the provisions o f the Loan Agreement. Such accounts and records will be maintained in a form acceptable to the Bank. The proceeds o f the loan deposited at the treasure account with CNB wil l be converted into local currency to cover budget expenditures. The Ministry o f Finance wil l be responsible for the loan administration and for preparing the withdrawal application, and maintaining the withdrawal application as required. The Ministry o f Finance, with the assistance o f CNB, will maintain records o f all transactions under the loan in accordance with sound accounting practices. Given the positive IMF’s assessment o f CNB, an audit o f the deposit account for the proceeds o f the loan i s not considered necessary. The Ministry o f Finance will provide the Bank within 30 days a confirmation letter stating that the PAL2 funds have been received and deposited into the designated account assigned by the borrower that forms part o f the Borrower’s budget management system.

D. Environmental Aspects

120. Environmental aspects of privatization: The proposed policy reforms have been screened in line with OP 8.6. The area with known environment linkages concerns the privatization o f state-owned companies which require a future Industrial Pollution and Prevention Control Permit (IPPC), or known pollution hot spotsheavily contaminated sites. The two steel mills and the aluminum plant privatized under P A L are likely IPPC facilities, in some cases with known environmental concerns such as

33

contaminated land. Shipyards may have legacy o f environment contamination issues, which will be important to clarify during privatization.

121. In 2005, Croatia initiated a program to address high priority pollution hot spots in cooperation with the Environment Fund, and carried out feasibility studies and prepared designs o f remediation o f several known heavily contaminated sites. Remedial actions have since been carried out on these sites.40

122. In the case o f the two steel mills and the aluminum plant privatized under PAL, environmental audits were carried out prior to their tendering, and, based on the audit results, bidding documents issued call for environmental investments by potential investors. In the case o f state-owned shipyards, the National Shipyard Restructuring Plan being prepared wil l address the environmental sustainability issues and mitigation measures in the context o f shipyard restructuring or liquidation.

123. Overall legislative framework on environment: The legislative framework in Croatia to address environmental l iabil i ty and industrial pollution issues i s not fully in place, but it i s actively being updated to align with the relevant EU Directives. A new Environment Protection Ac t was adopted in December 2006, which established the framework for IPPC Directive implementation. The World Bank joint ly with EC had supported a “mock” peer review o f the IPPC Directive to identify key challenges that would need to be addressed by the IPPC program. Among them was to clearly establish the environmental l iabi l i ty-continue the application o f the polluter pays principle, but clarify how and among which parties liability should be shared, particularly in the case o f earlier state-owned industries-and adopt regulation on procedures to define water, groundwater, and soil remedial targets. The current privatization law does make any references to the environmental issues, and historically systematic reviews o f environmental issues have not been carried out as a part o f the privatization process. To raise awareness o f this gap, the World Bank provided the authorities a policy note highlighting regional practice on the use o f environmental audits. As Croatia’s legislative framework continues to be updated, there i s an opportunity to link compliance plan agreements to specific facilities undergoing privatization. In the meantime, Croatian authorities have initiated an ad hoc process, acknowledging a need to move in this direction.

124. Environmental screening: P A L has proactively supported the inclusion o f environment screening for al l new legislation and policies as part o f the public administration reforms. The methodology for environment screening has been prepared, and i t s implementation started in 2007. Many public administration reforms promoted by PAL, such as depoliticization, professionalization, and performance budgeting are cross-cutting, and will positively affect the government’s capacity to administer environmental legislation. Government environment effectiveness suffers from institutional fragmentation and weak enforcement.

125. Croatia has a long history o f environmental impact assessment (EN) linked with the construction permitting process. Efficiency improvements in construction permitting supported under PAL are not expected to affect the implementation o f the E N process. Croatia has continued to align i ts E N procedures with EU, in particular focusing on expanding public participation and implementation o f Strategic Environmental Assessment.

These include asbestos depot Mravinscka kava and Red mud lakes in Obrovac for wh ich agreements for remedial actions have been signed; and asbestos factory Salonit, hazardous waste landf i l l Lenic Brdo, Kastela (radioactive) slag depot, Soviak pit near Rijeka for which remedial actions plans are currently being made. Other identi f ied hotspots include Coke plant Bakar and Ferro al loy factory Sibenik, wh ich bo th declared bankruptcy and have been undergoing part ial remedial actions since 2004.

40

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E. Implementation and Monitoring

126. Coordination of Reform Program Implementation: Successful implementation o f the proposed reform program will require effective coordination among various ministries and agencies, and between the Government and Bank. The Government has assigned the State Secretary o f the Ministry o f Finance to coordinate the P A L agenda within the Government. Further, State Secretaries o f ministries and heads of agencies involved in P A L have been responsible for coordinating reforms in each ministry, and are members o f an inter-ministerial PAL Coordinating Body. Finally, the Government, led by the Prime Minister, wil l oversee the whole reform effort and ensure prompt action on agreed reforms.

127. Bank’s Monitoring Arrangements: The reform program sets out qualitative and quantitative benchmarks and targets for the medium-term. The Bank team monitors and follows up on progress, and meets with Croatian authorities periodically to discuss next steps. The benchmarks are guideposts to signal when progress i s advancing or falling behind in any given area. If progress i s considered adequate, implementation o f the reform program wil l be supported through a subsequent operation, subject to the approval o f the Board o f Executive Directors. Annual adjustments wil l be made to the reform program as it evolves, to take into account the latest country developments, other donor support, and feasible options to realize the intended development goals.

F. R i s k s and Risk Mitigation

128. There are a number o f r isks that attend the operation. These are as follows:

129. Political risks: Political r isks remain high as the country has a coalition Government with a mere one seat majority in Parliament, and several proposed reforms are ambitious and politically challenging. Also, the next Parliamentary elections are scheduled for November 2007, and the country i s entering a pre-election period, which raises a risk of contemplation and adoption o f fiscally unsustainable policies and investments. However, reforms to be supported under P A L are consistent with the EU accession agenda, which i s expected to somewhat mitigate the risk. Further, to mitigate the risk o f other policy reversals during the 2007 pre-election period after the PAL2 Board, the whole Bank program in Croatia has been put on the line: if the PAL supported reforms wil l be reversed in 2007, the Bank program will immediately move to the low case scenario with further lending curtailed.

.

130. Capacity weaknesses: Capacity weaknesses could impede implementation o f proposed reforms. Capacity i s uneven and limited in several ministries, which may hinder the reform effort. However, investment projects that complement P A L and technical assistance by other donors are designed to mitigate some o f the capacity constraints.

13 1. External shocks: External shocks that have adverse effects on regional stability could seriously harm the reform effort. Given Croatia’s heavy reliance on tourism revenues, i t i s vulnerable to any deterioration in regional stability. However, P A L supported reforms to improve the investment climate are expected to mitigate the r isk through diversification o f economic activities.

132. Exchange rate risk: Given the high degree o f euroization o f the Croatian economy, the Croatian financial sector remains vulnerable to exchange rate risks. The Croatian National Bank has, however, taken several measures to control the risk by discouraging foreign borrowing by banks, monitoring foreign exchange exposures o f bank clients and strengthening supervision both for banks and joint ly with HANFA of non-banking financial institutions.

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Schedule 1

CROATIA

PROGRAMMATIC ADJUSTMENT LOAN (PAL)

Let te r o f Development Policy

Y

REP I BL C OF C R 0 - T MINIS1 RY OF FINANCE

R q . NO: 513-1407-122 sass; 441 -0i1oeoi /eo

Zagreb, April 19,2007

L

Mr, Paul WoHowlh Proeldent lnternatlonrl Bank for Reconrtruction and Donlopment 1811 H Streat, N.W. Wirhlnglon DC, 20133

Subject: LE'HCR OP DEVELOPMENT POLICY

Dear Mr, Wolfawik

1. I am writing to request, on behelf of the Government of the Republic of Croatia (Government), the second Ragrammatic AdJushnt Loan (PALZ) of EURIX) million to support our economic reform program. Thls Latter of Development Policy ssb out the key actlone that the Government is cwnmitted b undeReke over the rnodiumtenn to e n h e m economic growth in Croatla and make progress towards EU aceeesion.

I

2. The overarching abjecNa of our rdarm program is to promote economic growth and development in the country through (i) improving the inveslment climate; (ii) atronethening governance; and (iii) enhancing fiscal sushinability of wr sector programs. We aim to achieve the following overall outcomeo 6s stretch goals; (i) general government eipenditurea reduced from 50.5 percent of GDP In 2003 to 46 peront of GDP or blow In 2008, and tho fiscal dencit from 6.3 percent of GDP In 2003 lo below 3,O prwn t of GDP in 2008; (li) private ssclor sham in GDP increamed from 60 perwnt in 2003 to 70 percent or ebow in 2008; and (iii) FlAS snd Cost of Doing Business assessments indicating improved investment climate in 2008, Our reform plans to reach these outcomes are briefly as fdllows.

lmprovlng Invwtmrnt Cllmats:

3. Croatla's performance in term8 of entwpriee reetructuring, privatizab'oi, end creellon of an enabllng Invwtmsnt climate has been mixed, Hence, we am k m to press ahead with reforms that wlll over tlme promob private sector growth, Our reform p q r a m will fbws on four sets of reforms to improve investment dimate: prlvablion of atatwwned enterprises: establishment of financial discipline an rntrrprim8; ruduang tost of doing buainesa: and atrengthenlng the judiciary.

1

4, Privrfkafian and flquidatkn of SbtooWnd €n-w The Government intends to complete pnvaballon of stabowned enterprises by end 2008, It has become urgent to create space for the private sector, and to release the publlc arsete locked in these enterprises into more productive use. At the beginning of 2004, there wr8 still about 970 enkrprises 4th minority stab shams (0-50 percent). We sold or liquidated stab's minority shares In over 200 companies in 2004=2005, and in another 345 companies In 2008. We intend to sell or cancel the rcmainlng shares in 2007 and 2008, We ~ l a o plrn to prlvctlze or liquidate close to 160 companies that have majoflty state ownemhip (over 50 percent r$b ownership) during 20042008. These companies are mainly in tourism, agribusiness, ghipbuilding, and metal.proceeslng, and many of them are lass-maklq, heavily indebted, and sunriving only with direct stab subsidles, We started the privatization process by eelling through tender or auctions ten companies 4th majority state ownership in 2004, and sold or llquldated another 50 companies in 2005 and 2006. In addition, we have also started the process of privatfrstlon of three large loss-maken (two steel mills end one aluminum plant), We complekd the privetlullon of Steel mill Split and TLM by April 19, 2007, while the prlvetizetion of the Steel mill Slsak we inland to complete by Aprll 25, 2007. The rest of the companies from the CPF portfallo wo plan to soli in 2007-2008, In addition, we Will issue a bender for the state sheres in one shipyard in the second quarter of 2007, end plan to complete the sole of majority ahem in the third quarter of 2007. In parallel, wm have prepared a natlonal restructuring plan of shipyards, h i c h targeb long-term sustalnoble operalion of shipysrds with a level and a form of state eld conaietent with the EU State Aid Guidelines. In that context, we plan to prepare a Sdclal mitigation plan and introduce an rnvlrDnmental audlt of shipyards to be privatized, Finally, the slate had shores in eleven age-kombinats in early 2004, and has 8ince add ell of them apart fmm one. Glven Vuplk qro-combind rewimd no bid by the last fender closure on April 17, 2007 ym will rs-tender it by end April at further discounted terms, We intend to sell the remelntng agw kombinat by end June 2007. We have slso developed a strategy for enhancing agribusiness performance and privatization of ago-kombinats, which WB have implemented from mid-2005 onwards.

5. The Government has slso been working on drafting of the new Prlvetlzetion Law, which would Introduce an Employee Shere Ownanhip Plan (ESOP) model. However, it was decided to forgo the adoption of the new Privatization h w in 2007, and to retaln the legal framework for privatization unchanged kr the Umc being, All changes necessary for lhe Improved procedures in the course of prlvatkatlon matters, as well as final proposals on ESOP, are to be discussed after the elections Bcheduled for November 2007. The content of the new law Will be discussed and coordinated with the Bank at that tlrna.

6. lmprovfng Flnrncjel Dirc@/ho of htupdser: To ensure this round of privatization is successful, we plan to avoid the mistake made in tb prior round, and impose on privetired enterpriaes-snd unterprises overalUtard budget wnstraints. We adopted a medium-term corporste Sectol subeidy reduction plan that rats an overall annual ceiling to 6ubridles that lo tightened from one year to the next, We started the implementation of the plan In the 2005 budgel, and reduced enterprises rubsidles from 3,4 percent of GDP in 2003 to 277 percent of GOP at end 2005, to 2.24 percent of GOP In 2006, whereby we achieved the result better than planned which was set lo 2.44 percent of GDP, end intend to decrease them further to 2,2 percent of GDP in 2007, and la 2.0 percent In 2008,

2

7. We are also taking measurn to further reduce remelning entarprim arrears over the next three yean, This is done through: (i) quarterly monitoring and publicatton of public enterprises' balence Irhwb, including liabllities and receivables date; (ti) clearing the overdue liablllties to suppliers; and (iii) clearlng the overdue receivables from buyers and the Government by enforcing the cut of eupply tP non-payers. Overdue payables and receivables of public enterprises w m reduced by 64 and 19 percent, Mpeth'vdy, between and 2004 and December 2006. Government 8frbars to pubk enterprises declined by 44 p m n t (from HRKlSI million to HRK 86 mIUlon) from end 2004 to December 2006. Purchases of central Government and i b agenclrt from public enterprkos stlll do not follow contract terns. By enacting the new Public Procurement Lew In 2007, explicit and efficient framework for publlc procurament prpecdures will be set.

8. Raduelng Cost dfJoifig Burinru: We are also committed to creating en environment mat facilitates new business mtry and operahkn, While a number d adminiitrrtive MWS have boon dismantled In the past teW years, iignificant work remains, Thenfore, we have been undertaking reforms to d d n s s Ihle ls~ue. Amendmctnts to the Physlcal Plannlng and Construction laws in June 2004, rn well a amendments to the Utility Serviced Lsw In July 2004 were deeigned to reduce time and stnamllna the dminlatrative procudurn to obtain construction-related permits, By mid 2007, thmugh adoption of the new b w on Phfiieal Planning and Conitnrctlon, the Government p l m to replace the two current conabuction-related permits with a single one for a majority of buildingr except from buildings d special state importance. In additjon, we have Introduced a one stop shop for boslnefs ngktnllon In May 2005, which reduced the number of required steps from 14 to five only and the time for company registration to less than 15 days. Furthermore, the Government made a declslon In September 2008 to launch the regulatoty guillotlne, swialled HITROREZ, a c h aims to cut the redundant and buiiness-unfriendly legislation down by 3G40 percent by July 2007, which ie expded b bring iavings to bwiness sector at about 1.2-3 percent olGDP,

9 , 8brngthrnlng the JuUlclrry; In addition ta facilltadng new business entry, we need t0 ensure that business entry is unhindered, contra& and property righb are obsemd and protected, and the court syetem provldes lmportlnl and Bmclent adjudication of disputes. This will require strengthening of our judicial systm, In patticular improving efnciency of our courts, Insffkienei- in our court system have mutted In B wnsldtrthie backlog of court caseti; in early 2004 there were over 1.64 million a s 8 8 pendlrrg, while in November 2006 backkg has been reduced by 29 percent to 1.1 5 mllllan.

io. The Government her prepared a comprehensive judicis1 reform strategy to address deflclencies In the sourt Bystem and prepare it for the EU accwsion. To reduce the case backlog by 50 percent by 2008 and to reduce delay, In court proceedingo, w have taken three sets of meanurn. Fimt, we have transferred non-adJudlcativa tasks from judges. We flnt ahifted land registration from judges to mort derks in municipal courts In 2004. Other non-adjudicative functions=mforwment of court dsdslons, and partidly partjcipetian in electoral commissions- wore transferred to othsr judicial pereonnel or outside cwrts In 2005.2006, In additlon, commerelal registretion pmedures have been simplthd to reduce adminietratlve burden on judges. Second, we have introduced an eutomaW case management sptcm to wurts, and adopted an IT strategy to support that, We haw pllabd the system in four large courts, and also modified the Court Rules of Procedure to make the iystorn work. third, our Government Is also in the process of preparlng 8 plan to retianellze the court sysbm, with the ok~tive to ensure a more even ceselod distribution

among couh. We have so far completed the plan for rationalization of court network, end intend to ated if8 irnplementatlon in 2007. Mergen of mlsdsmeanor and municipal courts have begun on pilot basis,

I 1 . Enfurcement of contracts, creditor end p i p i t y rights through our judiciary is currenbly tirneconaumlng and uncertain, and as the fint step to remedy that we amended the Exocution Law in 2005, The Gawmmsnt adopted In 2006 8 regulaioq framework far bankruptcy trustees to reduce the average duration of a bankruptcy cam. A movable property collateral registry has been established.

StrongUlenln~ Govrmmw:

12. Good governance is one of prerequlsltes for private e e c b growth. Weaknesses in public admlnistration are recognized as significant Impeding facbxs far development, implementoUon, End enforcement of flrrcally-responslbla, prkrtaewtor=pmmoting pdlcks in Cmatla. H ence, our reform program focuaes on these areas.

13. Slrsnglhmhg public rdminirbrtion: An efficient, skilled, and motivated public administration k a prmquisitefor effrctlve Implementation of tegulalione and policies. H e m , we need to pay attention to the size, struchrre and munenUon of our publlc seervlce. We recognize the rbe of our public sector wage bill as a share of OW is hlgh by Internatlone1 standards, and hence plan to lake the following dep, io nduce it M o w 10 percent of GDP by 2008, and improve the efficiency of the public senice and adept It to the EU stenderda. At the same lime, it is important to note that the EU accession proeesr puts in front of Croatia new chailenges In terms of the quallflcatlon end the sire of the Croatian public administration:

14. First, we are committed to refwmlng our public ernployrnent legislation and rationalizing the mwerd system, Disregard of ialrry regulations, and Inconsistant classtflcetlon of aimilar jobs across ministries and agencies had contributed to the hlgh wage bill, whilr fragmented and too compremed salary structure made it dMcult to enract and retain skilled staff, As Ute flnt step to address these problems, we enacted In 2005 a new Civil Service Law that provide6 incentives for efficient, client-otfented, and performancebased public administration, One of our objeclives is to dapolltklz~~rofrrraionallze the clvll renrloe In 2001: that is addressed by the new Civil Service Law (whose depolltlclzatlon cleuses wlll become effeclive aner the 2007 Parllamentey elections), but also through amendmenh enacted In 2008 and early 2007 to the laws on Government Officials, Tnntfer of Power, and Conillct of Interest as well 88 the Sptom of State Adminisbetion which will be adopted by the Parliament in AprillMay 2007. To unify and decompress salary structures, WB Intend to submlt soon to the Patliammt the new l a w on Civil Sefvice Selariea, end have It enacted by September 2007, By September 2007, we also Intend to Introduce a new job classification Byetem for the avil service. Besides, we plan to do the same for the public service in 2008.

15. Second, we are also going to ratlonallze our organizatlonal structures. The number of minisbies and above all agencies has added to the fiscal prossum. We ham already slarted this process by reduclng the number of ministflea, However, we acknowledge that this is only the first step in a wider ratkneliration proctm that should also Include the review of internal structures and organization of rnlnirtries, the review d functions end organization of de-concentrated offices of state adminiatration, and rationalizslin of the size and organization of agencies, A methodological

4

framework for functional revlow waa devebped In 2004~2005, and @lot functlanal reviews were can id out in the Ministry of Health and Social Wetfare, Minibtry of Agrlcultun, and hw county oflces. In 2006 and early 2007, the tw state adminithion offires at the county level and the Ministry of Health and Social Welfare starled raticnakatlon efforts brued on the functlonai review result8. Furlhermore, the proamdings of the funclbnal reviews have been lnitlaied in another ten central stab adminletratlon bodies and in flva d a t l rdmlnlstratlon offices et county level, and lhe Implementation of the functbnel eudlt will itart sm. Funher, the Minietry of Flnanca launched a preparatkm of a gavemment-wide personnel and piytdl database In tho fall 2006 to more eMive ly control Ihe publlc wetor wage bill end the size of public administration. We Intend to pilot the system in sslecled rninlstrisa in 2007.

16. Third, strengthening the p o l i process is one of our prloribes. To increase quality and fiscal etfordebiYty of proposed polkie8, we amsndd In 2005 the Rulrr of P r d u r e of the Government to make impact awemoment (fiscal, social, envlronmenbl, and impact on competition and state aid) of plapo~ed new palidea and lma mandatory. We 8190 adopted a otandard methoddcgy for f l s d lmpod ossossment and stadd its implementation in June 2005, In 2006 and 2007, we developed and pibted dendard methodologles for eocid and environmental impact amsementu a8 well a8 for impad assesrment on competltlon and state eld, and wlll start thelr tmplementation in 2007,

17. In Ocbber 2006, the Government appcovsd the policy reform proposal for the new Law on General Administrative Proadurn. The new law b n d e d am a legal bed8 for a modern, citizen- ortented public adrnlnistration, ab well a8 to re=hrmonize the legislatian dealing with sdrninisbtive procedures. The current Law on General Administratlve Procedurer ia outdated, and needs to be comprehensively modernlad by introduction d new Inutitulee nnd solutions already attested In the European dminQLnrtlve practke. Currently, there are more than 65 laws wlth speclal edmlnbtrativeprocedunl provisions, This creates a situation confuelng for Judges, lawyers and citizens and has negative consequencm for Iqal recurity and protection of citizens' individual rights, and themfm pnsenb a emin problem as wll. By enacting the new Law on General Adminisbative Produne, all of tho rpeclal administrative procedures will be revised, while only the mod neceesary ones will be kept

I 8. tmpmvin@ pubtic urpffdfium rnn8pwnt: Measures to strengthen public expenditure management are alsu n d e d . Whlls we refonnod our budget process through the Budget Law in 2003, internal audit and Rnanciel control funcConr rquired strenathening, Hence, wo established inlernal audit units In all 13 line ministries, exuebudgebry funds, across additional nine central state Jnstltutiono and some local govsmmonf unlh, mnd a n in the proccss of ssteblishhg them also in borne large cities ond cauntles. The Mlnlstry of Finance has developed, and the Government has psaesd the Strategy of Dsvelopment of the Public Internal Financial Control Sy8tern. The adopted Rulsbodc on lnbrnel Audlt of budgetery beneficiaries provldw, among other thlngs, the methodology of work and requirements for sppalntmonts of certified internal auditore. The Internal Audlt Manual hag been prepared and the preparation of the Financial Management and Contrd (FMC) System Is undernay, Trelnlng of internal auditors and FMC staff has k n designed, In my capeclb as the Minister of Finmu, I have also passed the Code of Professional Ethics for Internal Audlton and a bmplate for the Internal Audit Charter, which lays out the rghb and obligations of internal audit End audited subject. Further, on December 15, 2006 the Croatian Parliament paaeed the law on the System of Internal Flnancisl Controls In the Public Sector,

5

19, The Ministry of Finance has also been sleadily sttengthening budget oxecutlon processes, including e#ountlng and repottlng. We have widened the coverage of the Treasury Single Account to include ail ertra-budgetlery funds, Further, we have assessed the functionality and overlap of exbting frnancid management and information systems In rnlnlsBlea and budget entities, and developbd a slrategy to stmngthsn the Treuury System to ratIanallre and integrate these systeme, rpeciflcally focusing an implementation of the commltmrnt control module ocmaa first level clpnding units, and debt management module in my ministry, We will start implementing this strategy during 2007.

20. new Public Procurement Law will be enacted in 2007,

We are in the prccess of harmonizing our public pmurement loglslatlon with the EU, A

Enhancing Fiscal Surtalnrblllly of S m r Program:

21. We recognize that the level and sfflcleffiy of rectorat ipending requires altenhn if we are to reduce the slze of the pubic sector, end improve our fiscal poaition. Our economic refwm program concintrah on improving health finanang; rationalizing social benefits: Improving fiscal and social sustrlneblllty of !ha psnsion syatem; and reducing k a l dcliclt of rallways.

22. Impmvlng hsrltlr flnmelrrg: Crostis is cuirently spending around eight and a half percent of GDP an health care, whlch Is high In cornpadoon to other counttie8 at drnllar income levels, Our ageing population, generous benefit packages and exemptions under the current health insurance, and rapldly lncreaslng cort of medical technojogy are further incrming the fiscal prerrsure. We are concerned of these trends, end determined to reduce deficita and improve suatainablllty of health finsnclng. Our goal will be to mduce total public spending on health to a sustainable level of six percent of GDP by 2008. To achieve thla goal, yw haw taken twp seb of measures lo rationalize health expenditures. First, to ruduce drug expenditures, we reduced In 2004-2005 time for dfug ngietratlon, expanded the number of eeneric drugs on the drug lid, and implemented contracts with limib on presuiptlons and referrals. Second and m a t importantly, to improve fiscal wtainabilily of the health Insurance syrtcm, we decided to reduce exemptions to cepayments, and restructure the complernmtpry health insuranca by eliminating co-payment covcnge for drugs. We have undertaken the following actions in 2006 and 2007: (i) two lists of drugs-wlth end wlthout co-payment requirementintroduced with target revenue8 of HRK 400- 500 millionlyear, (ii) in the Obligatory Health Insurance Law incometeating of cepaymenl exemptions strengthened by making the family definition consistent with Centers tor Social Welfare definitlon, and the Mnition of income expanded, (iii) HZOZO updated the list of unemployed eligible fa exemptlon; (Iv) MoHSW and HZOZO have asseased the revenues (alter exemption nimburremenb and admlnlstrativs anta) from lhe administrative fee, whlch amounted to HRK 308 million/year HZOZO atrengthened control rnechanlsrns and fee collection by end March 2007; (v) MoHSW prepard initial draft accreditation legislation by end March 2007; (vi) implementation of the lnltlal DRG model etarted In hmpltalr in mid-2006, end initiel evaluation and fiecei impact assessment of the first few months of implementdion was cornpleled by end March 2007; (vll) MoHSW completed the first phase of hospital masfer planning by end March 2007.

23, Rdbm ofrocirl bmrfltr: Them is also E need lo wnwlidete arid improve targeting of cash eocial benefits. Currently, Croatia is rpending on a d d benefits eignificantly more than other muntriee at canparable level of income, but the system fails to protect the most vulnerable

6

members of 8ocietyl 80 mod beneflb are not means tested. Poverty benefib represent only a small percentage of our spending. Hencel we e8Wlehd in 2005 an inter-ministerial worklng group t~ prepare and o v e m irnplernentatkn of a sbalegy for sdel benefib reform. Our goal is that by 2008 tobl rpending on Eoclal brndlb wlll be mduced tu 3,7 percent of GDP, while the share of the best-Wgckd and mewtested a i d aupprt allowance will inmase. To that effect, in 2007, wm will limit the tutal wclal bend! spending to 4 percent of GbP end increase the share of means-tested sock1 benefits. The strategy and an adlan plan wore campleted end sdapbd by the Government on April 12, 2007. Thelr Implemenbtian will star! in 2007, H o w w , unlike initially planned, the strategy is focusing on further wneolldatibn and ntreamllnlng of b e n d b under the contrd of the Ministry of Health end Soeiol Wehra.

24. impmwing f i e 4 md roclrl trrrlrinlbi@ of ttw pension ryrhm: In March 2004, Parliament passed amendments to he Pension Insurance Act, which integratd a pension supplement hto the bask pension and minbbducd full nominal wage Indexatton. As a result, pension expenditures as a share of ODP wen pmjected to Increase over the next ten yeam, instead of declining. At 13.4 percent of GDP In 2004, Croatian pension expenditures were already much higher than the EU average of 10.4 percent, and replacement rates ccmparable to other European eounlrles at 42 percent Given other Ihcal pressures on the budget, soon to be mounting EU acmslon related costs, and the impact of high labor costs on our competitiveness, thls ws a concerno Therefore, we dopted a fiscally and socially sustainable pensbn indexation formula in 2005 that allow us to contin end redua penslon spendlng below 12 percant of GDP by 2008, There will be no further emendmenb to the pendon in8urantr law durlng PAL.

25. /mpmwln# k c d ru8ldRrblllty ofnlhvrys: The kontian Railways (HZ) Is undegolng restnrcturlng. In 2004, Ht's apersUng cos@ were almost 2.5 rlrnso Mqher then Its revenues. Rhvonws of HZ do not even cover its labor casts, and annual state aid to the railways is about 1.7 percent of GDP (HRK 33 bllllon). The lev4 of subsldlss, whroh Is thrw tlmes the subsldy levels In EU countries, i i un8uBtainabls, and rapid action i8 needed to reduce operating cost8 of HZ. We are committed to restructure HZ, and rim to reduce the HZ working ratio to 150 p ~ n l by end 2008. HZ took actions needed io reduce the HZ wkinp ratio Lo 220 percent in 2005. This Included the following: (I) HZ IalddV 702 staff rlther through voluntary or Invalunt#y retrenchment from the motherwmpany by end June 2005, and these positions were eliminated; (ii) new hiring in 2005 wa6 limited b 80 new etaff: and (iii) 38 staR retired from H t in 2005. To reduu, the working rallo further to 190 percent at end 2006, HZ did the following in 2006; ( i ) HZ laM-off through vduntary and involuntary retrenchment 569 staff from the mother company and closed all positions left vacant; (ii) 34 staff left Lhs HZ mother company through nalual attrition; (iii) HZ new hiring w retained withln the iota1 100 new staff hiring limit. By end 2007, we are committed to reduce the HZ Group worklng ratlo to 170 percent. To achlwe that target, HZ All reduce ib 6taff In net t m s by at least 530 staff through a retrenchment program, natural attrition: involuntary layoffs, and limited new hiring. All ataff who choose voluntnry layoffa or the HZ Foundation, but no fewer then 240 staff, will leave the HZ Group by end June 2007, and those who choose invduntao layoffs will leave HZ by end 2007. The ebovemenkned measures were agreed upon in the form of the Minutes signed by the Sank, MSTTD and HZ at the beginning of Aprll,

26. In 2005, the Government issued a decfslon determining the legal framework governing HZ subsldlarj privatization. Our plan is to privatize ten HZ subsidiaries, We issued tenden for four subsidiaries by end March 2007 and plan to sell them by end June 2007. In addition, we wlll tender

7

another hvo by end June 2007 and the remaining four in the second haif of 2007. HZ has prepared a time-bound, stepbystep plan for subsidiary privatlzetlon that details the schedule,

27. Finally, to avold the achieved cod reduction been negatad by salary increases, in the n w collective agreement HZ sderisa are either frozen or Ilnked to the wrlrlng r o b improvement. If the working ratio has Mled to improve or deteriorated, no Way increases will be granted.

28, To improve flnanclal performance of HZ and reach the working ratio targets of 2006 and 2007, MSTTD prepared a program to reduce servim along uneconomic local tines in 2006-09. Thio program Is an integral pad of fhe Nafbnal Pragrm for Construction and Modernlzation of h e Railways Infrastructure lor 2007-2012. The Government will adopt the program and submit it to the Croatian Parliament by end June 2007.

29. In Eoncluslon, I wwld liko to reiterate the comrnltment af the Government to all these reforms, and I bust that thls request for World Bank support for lhdr lmplementatiorr will IIIceive your favorable consldoro!ion.

, .

: . . . . I

.. , . . . . .

8

Schedule 2

CROATIA

PROGRAMMATIC ADJUSTMENT LOAN (PAL)

Policy Matrix

E

I 7i

3

v)

I

4 ..

N

N

c n in Y

1 a c,

6 9 3 8 z 3 a !c b EI

9

Y

b !c 3 e ;; 6

(El

W

in

Y 1

in L 0 c,

E U in

pc P

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.I 3 c,

h 0 a 0 .I

.I

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L

2 in Y - I e a, * 3

2

2

2 .I be c,

5 a" .I I

d

Q

cd .I c,

EI u

s 0

-0 S

a,

S

.- .- *

3 5 e

s * -0 c

a2 v) 0

N i e, E .- - E .- B Y

0 8

s e, C

d

V .- 5 a n B 6 5

2 5

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N T

-

S 0 In 8 .-

n v)

6 .- * m M

0 e, 0

.- s

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a E z e, a e,

E

E P e, n In Y

0

Annex 1

Croatia at a glance 4/24/07

POVERTY and SOCIAL

2005 Population, mid-year (millions) GNI per capita (Atlas method, US$) GNI (Atlas method, US$ billions)

Average annual growth, 199945

Population (%) Labor force (%)

Most recent estimate (latest year available, 199945) Poverty (% of population below national poverty line) Urban population (% of total population) Life expectancy at birth (years) Infant mortality (per 7,000 live births) Child malnutrition (% of children under 5) Access to an improved water source (% of population) Literacy (% ofpopulation age 75+) Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1985

GDP (US$ billions) Gross capital fonationlGDP Exports of goods and services/GDP Gross domestic savingdGDP Gross national savingslGDP

Current account balance/GDP Interest payments/GDP Total debffGDP Total debt servicdexports Present value of debffGDP Present value of debffexports

1985-95 199545 (average annual growth) GDP -6.0 3.8 GDP per capita -6.0 4.2 Exports of goods and services 6.3

Croatia

4.4 8,370 37.2

-0.4 0.7

11 69 75 6

76 98 96 96 95

1995

18.8 17.6 38.6 6.7

10.8

-7.5 0.7

17.7 4.7

2004

4.3 4.3 5.7

Europe 8 Central

Asia

473 4,113 1,945

0.0 0.6

64 69 28

5 92 97

104 105 102

2004

35.6 30.6 47.5 21.7 23.6

-5.2 3.7

87.0 22.2

2005

4.3 4.2 4.6

Upper- middle- income

599 5,625 3,368

0.6 1.2

72 69 23 7

94 94

107 108 106

2005

38.9 31.0 47.1 22.6 23.3

-6.6 3.3

77.7 23.9

200549

4.3 4.4 5.9

Development diamond'

Life expectancy -

GNI Gross Per primary capita enrollment

-

Access to improved water source

Croatia - ~ Upper-middle-income group

Economic ratios*

Trade -

Indebtedness

Croatia - ~ UDDer-middle-income o r o u ~

STRUCTURE of the ECONOMY

(% of GDP) Agriculture Industry

Services

Household final consumption expenditure General gov't final consumption expenditure Imports of goods and services

Manufacturing

(average annual growth) Agriculture Industry

Services

Household final consumption expenditure General gov't final consumption expenditure Gross capital formation Imports of goods and services

Manufacturing

1985 1995

.. 10.7

.. 34.3

.. 24.3

.. 55.0

.. 63.9

.. 29.4

.. 49.5

1985-95 199545

-6.7 0.4 -12.6 4.1 -12.9 4.1 -1.1 3.3

3.8 0.4 8.7 6.5

2004 2005

7.8 7.6 31.1 31.6 20.5 20.9 61.1 60.8

57.3 56.9 21.1 20.5 56.4 55.5

2004 2005

9.7 0.1 5.8 4.8 7.4 5.8 2.7 4.2

4.8 3.4 -0.3 0.8 4.0 6.3 4.6 3.5

I 1 Growth of capital and GDP (%) 30 M 10

0 -10

1-20- -GCF -GDP I I Growth of exports and imports (%)

Note: 2005 data are preliminary estimates. Group data are to 2004.

The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete.

Annex 1

TRADE

Net transfers

l9SS

2 0 5 3

47 3 2 7

-2 5

1995

4 577

1 7

1

87 87 BB

1995

- 7 407

1 850 44.3

1 $85 5 2

1995

3 336 60

0

3

3.1 20

3

I20 50

7 22

2004

2 1 3 9

45 1

2004

a*

3 16 580 1.190 1 .$a7 5 739

1

2004

1 486

1 .DO8 -88

8 1511 8 0

2504

31 002

4,476 8%

0

265

26 7

209 Rb 61 35 26

9

2DOf

3 3 3 2

2005

8,955 487

1

72 72

1 ua

2005

30

5.129 7 04

It

I03 1 1

-1 345

86 80 70 9

33 -24

inflation f%)

4

a

Current account balance to GDP [st,)

22022 3

Coal 2: ensure that children are able to complete primary schooling Primary school enrollment [net "6) Primaw r ~ ~ ~ ~ e t ~ ~ n rate (% of relevant age group)

Yo SwandNy SCtlOOl enrollment Igross, %)

{% Of people ages 15.24)

and

Education indicators {%f

'25

IGT indicators (par 1,000 people)

* %a

Annex 2 - Croatia Social Indicators

POPULATION Total population, mid-year (millions)

Urban population (% of population) Total fertility rate (births per woman)

POVERTY (% of population) National headcount index

Urban headcount index Rural headcount index

Growth rate (% annual average forperiod)

INCOME GNI per capita (US$) Consumer price index (2000=700) Food price index (2000=700)

INCOMElCONSUMPTlON DISTRIBUTION Gini index Lowest quintile (% of income or consumption) Highest quintile (% of income or consumption)

SOCIAL INDICATORS Public expenditure

Health (% of GDP) Education (% of GNl)

Net primary school enrollment rate (% of age group)

Male Female

Access to an improved water source (% of population)

Urban Rural

Total

Total

Immunization rate (% of children ages 72-23 months)

Measles DPT

Child malnutrition (% under 5 years) Life expectancy at birth (years)

Total Male Female

Mortality Infant (per 7,000 live births) Under 5 (per 7,000) Adult (15-59)

Male (per 7,000 population) Female (per 7,000 population)

Maternal (per 700,000 live births) Births attended by skilled health staff (%)

Latest single year

1980-85

4.7 0.5

52.3

71

17

233 106

100

1990-95

4.7 -0.5 55.8

1.6

3,390 81

7.1

82

92 90 1

72 69 77

9 10

207 96 12

100

1999-05

4.4 -0.4 69.0

1.4

11.1

8,370 113

27.5 9.0

6.1

93

76

96 96

75 72 79

6 7

12 11 7

100

Same regionlincome group

Europe 8 Central

Asia

472.9 0.0

63.7 1.6

4,113 130

4.4

90 91 90

92 99 80

93 93 5

69 64 73

28 34

316 134 58 94

Upper- middle- income

598.7 0.6

72.0 1.9

5,625 126

4.6

93 94 93

94 98 82

91 94 7

69 66 73

23 28

286 150 91 95

CAS Annex 85. This table was produced from the CMU LDB system. 05/01 /07 Note: 0 or 0.0 means zero or less than half the unit shown. Net enrollment rate: break in series between 1997 and 1998 due to change from ISCED76 to ISCED97. Immunization: refers to children ages 12-23 months who received vaccinations before one year of age or at any time before the survey.

Annex 3 - Croatia Key Economic Indicators

Actual

2003 2004 2005 2006

Projections Base Case

2007 2008 2009 National Accounts (as % o f GDP)

100 7

32 61

76 33

5 28

48 57

24 24

42,915 8,880

4.8 10.5

4.6 3.0 3.3

21,413 10,606 24,658 21,117 -3,245 1,386

-3,175

3343 - 208 3,017

- 1,076 - 1,727

-7.6 -7.4

18.4 15.4

-3.1 45.1 40.1

4.9 8.0

Gross domestic product”) Agriculture Industry Services

Total Consumption Gross domestic investment

Government investment Private investment (incl. increase in stocks)

~ x p o r t s GNFS~) Imports GNFS~)

Gross domestic savings Gross national savingsc)

4emorandum items Gross domestic product (US$ mill at current prices) 3NP per capita (US$, Atlas method)

100 6

33 61

73 34 4

29

48 55

27 28

5 1,240 10,860

4.0 7.1

4.2 2.9 3.2

24,674 12,750 28,159 24,737 -3,485 1,586

-2,893

1200 - 691 2,582

307 - 505

-6.8 -5.6

5.0 5.0

-2.6 41.7 37.3 4.5 7.1

100 7

30 62

80 31 6

25

47 58

20 21

29,596 5,490

Leal annual growth rates (YO, calculated from previous years prices) Gross domestic product at market prices 5.3 Gross domestic investment 14.1

Leal annual per capita growth rates (YO, calculated from previous years prices) Gross domestic product at market prices 5.4 Total consumption 3.7 Private consumption 4.6

lalance o f Payments (US% millions) ~xpor t s GNFS~)

Merchandise FOB Imports GNFS~)

Merchandise FOB ilesource balance Vet current transfers lurrent account balance

Vet private foreign direct investment Vet portfolio investments Long-term loans (net) 3ther capital (net, incl. errors & ommissions) 3hange in reserve8

4emornndum items Resource balance (% o f GDP) Jurrent account balance (YO o f GDP) 4nnual value growth rates (“h)

Merchandise exports (FOB) Merchandise imports (FOB)

14,877 6,308

17,198 14,216 -2,321 1,407

-2,132

1926 964

2,719 - 2,161 - 1,401

-7.8 -7.2

26.1 33.5

’ublic finance (as % o f GDP at market prices)‘)

lurrent revenues 45.0 Jurrent expenditures 42.6 h r r e n t surplus (+)/deficit (-) 2.3 lapital expenditure 8.7

3verall surplus (+)/ deficit (-) (without capital revenue) -6.4

100 8

31 61

78 31

6 24

47 56

22 24

35,645 7,020

4.3 4.8

4.3 3.5 4.9

17,583 8,210

20,126 16,560

1,486 -2,543

-1,841

877 261

2,547 - 1,804

- 68

-7.1 -5.2

30.2 16.5

-4.8 45.1 41.1

4.1 8.9

100 8

32 61

77 31

5 26

47 56

23 23

38,883 8,000

4.3 6.3

4.2 2.7 3.4

18,876 8,955

2 1,702 18,301 -2,825 1,475

-2,576

1550 - 1,345

2,000 1,333

- 1,022

-7.3 -6.6

9.1 10.5

-3.9 44.9 41.1

3.8 7.7

100 7

32 60

75 33

5 28

51 58

25 26

44,667 9,510

4.6 7.9

4.6 2.8 3.0

22,588 11,349 26,084 22,437

1,483 -3,496

-3,131

2665 - 1,470

2,753 - 136 - 721

-7.8 -7.0

7.0 6.3

-3.0 44.1 39.4 4.7 7.7

100 7

32 61

73 33

5 29

50 56

27 28

47,851 10,060

4.0 6.9

4.1 2.9 3.1

23,720 12,143 26,981 23,559

1,531 -3,261

-2,787

1565 - 1,017

2,655 480

- 895

-6.8 -5.8

7.0 5.0

-2.8 42.6 38.0

4.5 7.4

Foreign financing

Monetary indicators M4iGDP Growth o f M4(%) Private sector credit growth (%) Domestic credit / GDP (%)

Price developments Real exchange rate (1995=lOOf Exchange rate at end year (LCUiUS$f Real interest rates Consumer price index (% changey GDP deflator (% change)

3.0 2.0 -I .8 -1.1

65.0 65.1 66.8 72.8 11.0 8.6 10.5 18.0 14.6 14.0 17.2 22.9 56.3 59.2 64.5 73.2

102.2 99.0 96.6 103.7 6.1 5.6 6.2 5.6 9.8 9.4 6.5 6.0 1.8 2.1 3.3 3.2 3.9 3.9 3.2 3.4

-1.71

-0.8 -0.5

77.3 78.7 13.5 10.0 19.3 13.9 81.6 86.0

106.5 107.4 6.0 6.1 7.1 6.8 2.7 2.5 3.4 3.2

79.4 8.0

11.9 89.9

107.4 6.1 6.3 2.5 3.1

a) GDP at factor cost b) 'GNFS" denotes "goods and nonfactor services" c) Includes net unrequired transfers excluding official capital grants. d) Includes use o f IMF resources. e) Consolidated general government. f) "LCU" denotes "local currency units". An increase in real exchange rate denotes depreciation. g) Retail price index by 2002; since 2003 CPI

Annex 4 - Croatia Key Exposure Indicators

Actual Indicator 1999 2000 2001 2002 2003 2004 2005 2006

Projections Base Case 2007 2008 2009

Total debt outstanding and 10143 11282 11870 15680 24759 31002 30220 38181 disbursed (TDO) (US$m)a

Net disbursements (US$m)a 1243 1533 905 2146 6383 4093 2966 4951

Total debt service (TDS) (US$m)a

1937 2235 2968 3233 3254 4476 5129 5095

Debt and debt service indicators (%I

TDO~XGS~ 124.9 130.6 123.1 148.1 166.4 176.3 160.1 178.3 TDO/GDP 51.0 61.3 59.8 68.1 83.7 87.0 77.7 89.C TDS/XGS 23.9 25.9 30.8 30.5 21.9 25.5 27.2 23.8 Concessional/TDO 2.9 2.9 2.7 0.0 0.0 0.0 0.0 0.C Interest paymentsiGDP 2.8 2.6 2.7 2.2 11.0 12.6 13.2 11.9

IBRD exposure indicators (%) IBRD DSipublic DS 6.2 3.7 2.5 3.2 5.7 4.7 5.6 6.4 Preferred creditor DSipublic DS (%)' 18.8 11.7 8.5 17.4 12.2 9.3 10.0 1O.C

IBRD DSiXGS 0.5 0.5 0.4 0.5 0.5 0.5 0.5 0.5 IBRD TDO (US$m)d 399 421 472 617 782 851 809 969

38598 40554 4247

2648 2592 285

5507 5610 531

170.9 171.0 172. 86.4 84.8 82.' 24.4 23.7 21.. 0.0 0.0 0.1

12.3 11.7 1O.d

6.5 6.7 8.: 10.0 10.3 12.(

0.4 0.4 0.: 1097 1109 1099

a. Includes public and publicly guaranteed debt, private nonguaranteed, use o f IMF credits and net s b. "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the

Bank for International Settlements. d. Includes present value of guarantees. e. Includes equity and quasi-equity types o f both loan and equity instruments.

term capital.

W O * O

x

m * . B m m 0 0 0 0 0 0 0 0 0 0 N N N N N

m Y

2 P

x P

PI

N x

E

E

Y c VI z z 4 e c 4 w 9 c

P

P rn

0 a m

Annex 6 - Croatia Staement o f IFC's

Committed and Outstanding Portfolio As of02/28/2007

(In U S Dollars Millions) Committed Outstanding

Approval F Company Loan Equity Quasi Partic Loan Equity Partic 197318 1 /98. Belisce 15.6 6.0 0.0 8.5 15.6 6.0 8.5 2006 Belje 52.6 0.0 0.0 0.0 52.6 0.0 0.0 1999 Croatia Cay 0.0 2.3 0.0 0.0 0.0 2.0 0.0 19991 2002 E&S Bank 19.3 0.0 0.0 0.0 19.3 0.0 0.0 2005 PBZ 98.7 0.0 0.0 0.0 98.7 0.0 0.0 2004 Schwarz GI 47.7 0.0 0.0 0.0 47.7 0.0 0.0 2000 Viktor Len; 0.1 0.0 0.0 0.0 0.1 0.0 0.0

Total Portfolio: 233.9 8.3 0.0 8.5 233.9 8.0 8.5

Annex 7 - Croatia Selected Indicators* of Bank Portfolio Performance and Management

Indicator 2004 2005 2006 2007 Portfolio Assessment Number of Projects Under Implementation a 13 13 15 15 Average Implementation Period (years) 3.3 3.0 2.7 3.1 Percent of Problem Projects by Number 38.5 0.0 6.7 0.0

Percent of Projects at Risk by Number a, 38.5 0.0 6.7 0.0

Disbursement Ratio (%) e 41.5 27.3 19.3 9.0 Portfolio Management CPPR during the year (yesho) Yes no yes yes Supervision Resources (total US$) 828 1004 1176 1260

' Average Supervision (US$/project) 80 71 82 84

Percent of Problem Projects by Amount 37.1 0.0 7.7 0.0

Percent of Projects at Risk by Amount a, 37.1 0.0 7.7 0.0

Memorandum Item Since FY 80 Last Five FYs Proj Eva1 by OED by Number 17 8 Proj Eva1 by OED by Amt (US$ millions) 899.5 452.5 % of OED Projects Rated U or HU by Number 29.4 12.5 % of OED Projects Rated U or HU by Amt 21.9 5.8

a. As shown in the Annual Report on Portfolio Performance (except for current FY). b. Average age of projects in the Bank's country portfolio. c. Percent of projects rated U or HU on development objectives (DO) and/or implementation progress (IP). d. As defined under the Portfolio Improvement Program. e. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the

beginning of the year: Investment projects only. * All indicators are for projects active in the Portfolio, with the exception of Disbursement Ratio,

which includes all active projects as well as projects which exited during the fiscal year.

Annex 8 - Croatia Croatia - IFC and MIGA Program, FY 2004-2007

2004 2005 2006 2007

IFC approvals (US$m) 54.42 102.05 49.26

Sector (%) Finance & Insurance Food & Beverages Industrial & Consum Wholesale and Retai Total

Investment instrument(%) Loans Equity Quasi- Equity Other Total

MIGA guarantees (US$m)

11 89

100

100 0 0

100

146.13

100 100

100

100

100

0.00

100 0

100

100 0

0.00

Annex 9 - Croatia Summary of IBRD Nonlending Services

FY 2005 - FY 2008

Product Completion FY Cost (US$OOO) Audience a/ Objective

Completions To Date During CAS Period Fiduciary Country Systems Development

Energy Reforms and Regional Integration Private Sector Participation Options in Roads (PPIAF) Regional Development & Living Standards Environmental Management Strategy Reform and EU Accession Policy NotesNorkshops dl

Shipyards SOE Restructuring PSlA Independent Procurement Review IDF Grant: Capacity Building for Monitoring

IDF Grant: Strengthening Budget Management

for EU Integration TAllFA

Judicial Efficiency

Underway e/

Environment TA Public Finance Review ROSC Accounting and Auditing Update ROSC Corporate Governance IDF Grant: Enhancing Corporate Financial Reporting Fiduciary Monitoring Statistical Capacity Building

Planned e/

EU Convergence Study FSAP

05 05 06 06 06 06 06 07

07 07

07 07 07 07 10 07 08

08 08

119 36 80 275 160 200 72 48

350 368

75 220 47 29 350 62

100"

250 TBD

Other TBD 08 TBD

GIDIB GIDIBIPD GIDIBIPD GIDIBIPD

GIDIB GIDIBIPD

GIDIB B

KGIPS KGIPDIPS KGlPDlPS KGIPDIPS

KGIPS KGIPDIPS

KGIPS KGIPS

KGIPS G G KGIPS

GIDIB KGIPS GIDIB KGlPS GIDIB KGlPS GIDIB KGIPS GIPD KGlPS GIDIB KGlPS GIDIB KGIPS

GIDIBIPD KGIPDIPS GIDIBIPD KGIPDIPS

TBD TBD

a1 Government (G), Donor (D), Bank (B), Public Dissemination (PD). b l Knowledge Generation (KG), Public Debate (PD), Problem-Solving (PS). c l Institutional Fiduciary Assessments (IFAs) to focus in particular on the social sector and environment

ministries and agencies. d l To assess impact of policy option implemented elsewhere (e.g., EU8, other MICs, and OECD countries) in policy

areas such as Public Administration Reform, Health, Railways, Public-Private Partnership for Municipal Services, Judicial Reform, Education, Decentralization, and Cost of Doing Business.

el Costs shown for these tasks are estimates. f l Of which US$ 90,000 from trust fund.

Annex 10 - Croatia Fund Relations Note

Public Information Notice (PIN) No. 07/22 February 22,2007

International Monetary Fund 700 19Ih Street, NW Washington, D. C. 2043 1 USA

Republic of Croatia: Public Information Notice

On February 16, 2007, the Executive Board o f the International Monetary Fund (IMF) concluded the Article I V consultation with the Republic o f Croatia.

Background

Croatia has experienced solid growth and low inflation in recent years, with GDP growth averaging around 4% percent in 2001-06 and headline inflation contained to 2 -4 percent. But domestic demand pressures and higher international energy prices caused the current account deficit to widen in 2005-06.

Although external competitiveness appears adequate, export growth has been significantly below the average in Croatia’s peer countries, which have been more successful in attracting greenfield foreign direct investment. Survey measures o f competitiveness underscore structural weaknesses in the business environment.

Policies in 2004-06, supported by a precautionary Stand-By Arrangement, sought to mitigate external vulnerabilities by lowering Croatia’s current account deficit and stabilizing the external debt-to-GDP ratio. The authorities largely relied on fiscal adjustment, accompanied by measures by the Croatian National Bank (CNB) to safeguard financial sector stability and discourage external debt accumulation by banks. Reform o f pension indexation, wage moderation, and investment cuts contributed to a reduction in the fiscal deficit from 6.1 percent o f GDP in 2003 to an estimated 2.8 percent in 2006. However, despite these countervailing policy efforts, gross external debt and the current account deficit remain high.

While bank restructuring and privatization have strengthened the financial sector, strong credit expansion and foreign exchange-induced credit risk have raised concerns. Large foreign banks own over 90 percent o f the system, which i s well developed by regional standards. Financial soundness indicators show adequate capitalization and asset quality. But intense competition among banks and easy access to credit from foreign parents has contributed to a vigorous credit expansion that gained momentum over 200546. The pace o f the ongoing credit expansion increases the potential for asset quality to deteriorate in the event o f a downturn. Moreover, most households also seem exposed to currency risk: the bulk o f long- te rm bank loans to households are linked to foreign currencies; and, even though households’ foreign- currency deposits are sizeable in the aggregate, borrowers and savers may only partly overlap. Concerned about safeguarding financial stability, the CNB responded with a series o f measures to slow the bank- related portion o f capital inflows: a progressive increase in its marginal reserve requirement on banks’ foreign borrowing, broadening i t s base, and issuing various prudential measures and guidelines.

The large role o f the state, slow progress in key structural reforms, and less-than-satisfactory conditions for doing business have constrained economic performance. While recent progress in some transition indicators has been significant, privatization and reform o f state-owned enterprises has lagged because o f

legal disputes, resistance o f vested interests, onerous investment and employment conditions, and a legal fkamework favoring insiders-a bias that the pending draft privatization l a w could worsen. In addition, conditions for doing business are hampered by the heavy administrative burden and difficulties enforcing property rights, with many problems at the local level.

The consultation focused o n the interrelated issues o f h o w to raise economic growth in Croatia and addressing vulnerabilities.

Executive Board Assessment

Croatia’s recent economic growth has been solid and inf lat ion contained, and i t s progress with the EU accession process has boosted investment prospects. However, the high external debt-to-GDP ratio, the increase in short-term external debt, and the widening current account deficit are sources o f concern. Directors welcomed the improvements in policies in recent years, but noted that continued efforts will be needed to address significant external vulnerabilities. They stressed the importance o f faster and deeper structural reforms if Croatia i s to boost potential growth. Progress in these areas should be high o n the agenda o f the next government.

T o address external vulnerabilities and reduce the burden o f the large government o n economic growth, Directors recommended more ambitious fiscal consolidation than the authorities’ medium-term plans currently envisage. In this connection, i t will be essential t o resist spending pressures in the run-up to elections in late 2007-including through off-budget proposals to address spending demands-and to ensure a fiscal deficit in 2007 n o larger than the budget target. Measures are also needed to reduce public expenditure permanently, with a v iew to providing room for cutting taxes, including social security contributions, in order to boost growth whi le lowering the budget deficit. Act ion o n the fiscal front will also help narrow the large current account deficit and ensure a sustainable debt path. With Croatia’s expenditure-to-GDP ratio w e l l above that o f peers, Directors saw considerable scope for savings, and encouraged the next government to make significant progress in this area.

Directors agreed that the present monetary framework remains appropriate for Croatia. Given the high degree o f euroization, the openness o f the economy, and adequate external competitiveness, they supported the tightly managed exchange rate. At the same time, not ing the constraints this places o n monetary policy, Directors emphasized the importance o f other supporting policies, including structural reforms, to strengthen competitiveness; fiscal consolidation, to redress macroeconomic imbalances; and strong financial sector supervision, to address possible balance-sheet currency and maturity mismatches.

Directors welcomed the progress achieved by the authorities in improving financial sector supervision and regulation. They commended the Croatian National Bank’s efforts over the past few years to strengthen the prudential regulation o f banks-which remain profitable and wel l capitalized-as w e l l as the recent establishment and development of the independent nonbank supervisor. Directors shared the authorities’ concerns about the prudential and macroeconomic r i sks o f the ongoing rapid growth in bank credit. They commended the Croatian National Bank for standing ready to address r i s k s associated with bank foreign borrowing and rapid credit growth. They nevertheless expressed reservations about the recent reintroduction of direct credit controls, whose impact, including undesirable side-effects, will need to be monitored closely. Directors encouraged the authorities to consider tighter prudential measures that would also raise credit quality and reduce vulnerabilities.

2

Directors called for significant improvements in the business environment. Reducing the administrative burden, legal uncertainties, and corruption will be critical in the coming years for attracting a much- needed increase in greenfield foreign direct investment required to boost exports and economic growth while lessening vulnerabilities. Noting the slow pace of recent structural reforms, Directors stressed the urgency of restructuring the loss-making shipyards, reforming the remaining public enterprises, and removing impediments to privatization.

For questions please contact Mr. David Moore, Senior Economist, European Department, IMF, tel. 202-623- I 9391

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