The main economic challenges facing Croatia are its high debt, high unemployment, a weak and fragmented public administration, high corporate debt and structural weaknesses in the education and social protection systems, the European Commission said in a report on Friday.

The Commission released country reports on economic and social challenges faced by the EU member states, accompanied by an in-depth review of macroeconomic imbalances for 18 member states, including Croatia. The reports will serve as the basis for discussion with member states of their national policy choices ahead of their national programmes in April, and will lead to the formulation in late spring of the Commission's country-specific recommendations.

The in-depth review of the situation in Croatia revealed that the high and still rising public debt was a heavy burden for the economy and a source of vulnerability. "The increase was mainly driven by high deficits and costs induced by state-owned enterprises," the report says.

"Private sector debt is at a high level and is not declining and the high stock of non-performing loans remains a challenge for the financial sector. So far, Croatia has experienced rather limited deleveraging and private debt has remained at high levels. This is especially true for the corporate sector, which in 2014 stood at around 80% of GDP, while household debt represented some 40% of GDP. High corporate debt is concentrated in sectors with low profitability and is reflected in the deterioration of banks' portfolio," the Commission warns.

The Commission says that "the capacity of the banking sector to support the recovery may be constrained by the impact of the legislation adopted in September 2015 which allows for the conversion of household CHF loans to EUR, as it implies losses for the banks."

The sizeable external debt is an additional constraint on the economy. "Net external liabilities amount to almost 80% of GDP and are dominated by foreign-currency denominated debt, with only a small share of liabilities represented by equity. (...) Moreover, almost one third of external debt is government debt, which implies sustainability risks," the Commission says.

High unemployment rate, a fragmented public administration, inefficient state-owned enterprises...

The Commission notes that the unemployment rate remains very high, especially for youth and the low skilled. "More responsive wage dynamics and flexible contracts contribute to labour market adjustment, but high unemployment and low activity rates weigh on the economy's potential," the report says, adding that long term unemployment rates are still about twice as high as the EU average.

The Commission says that "a weak and fragmented public administration weighs on service delivery and penalises business while inefficiencies in state-owned enterprises slow down the adjustment process."

"The decentralisation of functions to sub-central levels of government in the 2000s went beyond their fiscal capacity, generating strong reliance on central government transfers. At the same time, disparities in the fiscal capacity of local units result in regional inequalities in the services provided," the report says. State-owned enterprises "markedly underperform private companies and continue to weigh on public finances".

The education and social protection system suffer from structural weaknesses. "Although ambitious measures are being taken to improve the quality of education, shortcomings in the education system make it difficult for graduates to make the transition to the labour market and for adults to re-enter it," the report says.

The Commission notes that "the active labour market policies targeting young people have started to show good results but activation of the long-term unemployed is still unsatisfactory."

"Inefficiencies in the design of the social protection system result in high levels of poverty and social exclusion, leaving the most vulnerable with inadequate protection. Both the current and future adequacy of pensions is low and creates high risks of poverty in old age, especially for those with short working lives," the report says.

Limited progress in 5 recommendations and substantial in 1 recommendation

Regarding the country-specific recommendations, the Commission has established that Croatia made limited progress in addressing five recommendations, and substantial progress in one recommendation, that is in reinforcing the pre-insolvency and insolvency frameworks for businesses.

In the latest report, the first recommendation, in which limited progress has been made so far, obliges Croatia to ensure the correction of excessive deficit by 2016 by taking necessary measures in 2015 and reinforcing the budgetary strategy for 2016.

Croatia is advised to publish and implement the findings of the expenditure review and to improve control over expenditure at central and local level, in particular by establishing a sanctioning mechanism for entities breaching budgetary limits.

Croatia is recommended to "adopt the Fiscal Responsibility Act and strengthen the capacity and role of the State Audit Office as well as to introduce a recurrent property tax."

The Commission recommends reinforcing public debt management, in particular by publishing on an annual basis a debt management strategy and ensuring adequate resourcing. 

The second recommendation concerns discouraging of early retirement by raising penalties for early exits.

Croatia is asked to "improve the adequacy and efficiency of pension spending by tightening the definition of arduous and hazardous professions and Zagreb is also expected to tackle the fiscal risks in healthcare."

The third recommendation is about tackling the weaknesses in the wage-setting framework.

Croatia is advised to "foster the alignment of wages with productivity and macroeconomic conditions, in consultation with the social partners and in accordance with national practices."

Also recommended is the strengthening of incentives for the unemployed and inactive to take up paid employment. Croatia is asked to carry out, based on the 2014 review, "the reform of the social protection system and further consolidate social benefits by improving targeting and eliminating overlaps."

The fourth recommendation is about reducing "fragmentation and overlap between levels of central and local government as a comprehensive reform of local governance is lagging behind and the rationalisation of the agency system had been initiated but is currently on hold." Croatia should improve transparency in state companies, notably in managerial appointments and competence criteria.

The fifth recommendation with limited progress so far urges significant reduction of parafiscal charges. Croatia is asked "to remove excessive barriers for service providers" and to "identify and implement steps to improve the efficiency and quality of the justice system, in particular commercial courts."

According to the last, sixth recommendation, Croatia is advised to "reinforce the pre-insolvency and insolvency frameworks for businesses in order to facilitate debt restructuring and put in place a personal insolvency procedure." The Commission suggests strengthening the capacity of the financial sector "to support the recovery in view of challenges from high non-performing corporate loans and foreign currency mortgage loans, and weak governance practices in some institutions."

Substantial progress was identified in reinforcing the pre-insolvency and insolvency frameworks for businesses and putting in place a personal insolvency procedure "as implementation of the amended corporate insolvency legislation is expected to contribute to faster resolution of impaired debt and the legislative framework for personal insolvency entered into force, tough implementation could prove challenging."

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