Croatia's new government will be faced with major policy challenges, ranging from high public and external debt to high unemployment and weak governance, reads a European Commission report on Croatia's progress in rectifying economic imbalances.

The European Commission published its third report called "Croatia - Review of Progress and Policy Measures Relevant for the Correction of Macroeconomic Imbalances" several days ago, but wrote it when Croatian politicians were negotiating on the new parliamentary majority, following the November 8 election. The reports gives an overview of the economic situation in the period between February and December 2015.

"The nascent economic recovery provides an opportunity to step up the reform momentum decisively. The new government will be faced with major policy challenges, ranging from high public and external debt to high unemployment and weak governance. Much of the preparatory work for the requisite structural reforms and fiscal adjustment has been done, but the authorities' commitment to the reform agenda needs to be re-affirmed and implementation stepped-up," reads the report.

After six years of recession, Croatia is set to return to positive growth in 2015. Economic activity picked up strongly in the first three quarters of the year. 

"The rising general government debt is a source of concern," the Commission says, adding that according to its 2015 autumn forecast, it will reach 89.2% of GDP in 2015 and increase further to 92.9% by 2017.

 While the budget deficit is expected to fall to 4.9% of GDP in 2015, it will likely be the highest deficit ratio in the EU. 

The Commission notes that some steps have been taken to improve budgetary planning and tighten expenditure control, but measures to strengthen the fiscal framework are facing delays. 

"Although Croatia's increasing financing needs highlight the importance of developing and maintaining reliable financing sources, no steps have been taken to reinforce public debt management," the Commission says.

The decrease in the unemployment rate initiated in 2014 continued in 2015, but the rate remains very high, the Commission notes. "Preparatory steps have been taken towards reform of the wage-setting framework in the public sector, but concrete measures have yet to be adopted.  Recent measures in support of youth employment are starting to bear fruit and steps have been taken to combat undeclared work."

"The number of people retiring early decreased in the first half of 2015, but policy action aimed at encouraging particular categories of workers to stay in employment longer has been put on hold," the report says.

The Commission notes that weaknesses remain in public sector governance. "A comprehensive reform of local governance to overcome fragmentation and administrative weaknesses is not in sight, although limited action was taken to establish a legal framework for the merger of local government units and streamline the state agency system."

The Commission also notes that the business environment will benefit from recent steps to reduce administrative burdens and reform the insolvency framework. "There was some progress in decreasing the burden of parafiscal charges on businesses and first concrete steps were taken to reduce the administrative burden on business."

The Commission also criticises Croatia's lengthy court proceedings and sizeable backlogs which still hamper the efficiency and quality of the justice system, despite improvement in some areas. "The effective implementation of the recently reformed corporate insolvency framework and the new personal insolvency legislation will help speed up liquidation and restructuring proceedings and allow citizens to discharge their debts."

The report also underlines that banks’ lending activity remains subdued, also owing due to the still high rate of non-performing loans.

The Commission also notes that the authorities’ plan to conduct an independent asset quality review of the Croatian Bank for Reconstruction and Development's (HBOR) credit portfolio in 2017 is welcome, given the crucial role HBOR is having in the economy and the fact that it increasingly engages in direct lending activity. 

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