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June 18, 2013
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Croatia’s membership: A success for Croatia and the EU. Croatia will join the European Union on July 1, 2013 as its 28th member. It will be the second ex-Yugoslav state to become an EU member after Slovenia, which joined in 2004. Germany was the last EU country to ratify Croatia’s accession treaty in May, clearing its way into the EU. [more]
Croatia facing challenges on the EU’s doorstep Research Briefing Emerging markets Croatia’s membership: A success for Croatia and the EU. Croatia will join the European Union on July 1, 2013 as its 28 th member. It will be the second ex- Yugoslav state to become an EU member after Slovenia, which joined in 2004. Germany was the last EU country to ratify Croatia’s accession treaty in May, clearing its way into the EU. Both from the Croatian and the EU perspective, the accession process has been a success. Croatia has made great strides regarding its political and economic integration into Europe, providing a template for the rest of the Western Balkans. From the EU perspective, the accession confirms that the European ideal is alive and that joining the EU is still attractive, despite the current woes in the eurozone. Weak economic standing on the eve of EU entry. The combination of an unfavourable external environment and subdued domestic demand has taken a toll on the Croatian economy. Due to its strong trade and financial links, Croatia has been heavily exposed to the eurozone crisis. Croatia is one of the few countries where real GDP has not grown at all since the beginning of the global financial crisis. This has worsened the fiscal picture, with public debt approaching 60% of GDP. Substantial medium-term benefits of EU entry but structural problems need to be solved first. In the medium term, full access to the single market, increased investor confidence and stronger financial integration should boost the economy – provided that Croatia manages to implement overdue structural reforms, in particular tackling a rigid labour market, an overblown public sector and a weak business climate. This means that short-term gains from accession will be few and far between. Euro adoption not before the end of the decade . By entering the EU, Croatia implicitly agrees to also adopt the euro in the future. However, previous EU enlargement rounds in 2004 and 2007 have shown that it usually takes new member states several years until euro adoption. Currently, Croatia only satisfies one of the five Maastricht criteria in full. Especially in light of the fiscal challenges, it is highly unlikely that Croatia will join the eurozone before 2020. Authors Kevin Koerner +49 69 910-31718 kevin.koerner@db.com Tilman Bletzinger Editor Maria Laura Lanzeni Deutsche Bank AG DB Research Frankfurt am Main Germany E-mail: marketing.dbr@db.com Fax: +49 69 910-31877 www.dbresearch.com DB Research Management Ralf Hoffmann | Bernhard Speyer Croatia Capital Zagreb Population (m) 4.4 GDP per capita (EUR) 9,839 12,972 Currency kuna 2012 2013F 2014F GDP ( real, % yoy ) - 2.0 - 0.7 1.2 Inflation (% yoy, aop) 3.4 3.0 2.5 Current account (% GDP) - 0.1 0.0 - 0.5 Fiscal balance (% GDP) - 3.8 - 4.3 - 4.0 Public debt (% GDP) 53.7 58.0 62.0 Sources: IMF, EC, national authorities, DB Research June 18, 2013 Croatia facing c hallenges o n the EU’s doorste p 0 10 20 30 40 50 60 70 80 SI CZ SK EE LT HU PL HR LV RO BG 2000 2011 Income convergence in the EU 1 Sources: Eurostat, DB Research GDP per capita (PPS), index (EU15=100) Note: EU15 are AT, BE, DK, FI, FR, DE, GR, IE, IT, LU, NL, PT, ES, SW, GB; PPS: purchasing power standard Croatia facing challenges on the EU’s doorstep 2 | June 18, 2013 Research Briefing Croatia’s course into the EU Croatia will join the European Union on July 1, 2013 as its 28 th member. It will be the second ex-Yugoslav state to become an EU member after Slovenia, which joined in 2004. The European Commission’s last monitoring report in March 2013 confirmed that Croatia had fulfilled the remaining conditions on competition policy, the judiciary and fundamental rights as well as justice, freedom and security. The last real obstacle to Croatia’s accession was overcome at the beginning of April when Slovenia ratified Croatia’s EU accession treaty. A decade-long dispute between the two countries over Ljubljanska Banka going back to the partitioning of the former Yugoslavia had finally been settled. A border dispute between the neighbouring countries had already halted accession negotiations in 2008/9 for one year. Finally, with the approval of the accession treaty by the German Bundestag on May 16, the last formal hurdle for Croatia’s EU accession was removed. Germany was the last of the 27 current EU member countries to ratify the treaty. Croatia had already applied for EU membership in 2003 and started accession negotiations in 2005. This ten-year period between application and accession matches the average time it took for the 12 new member countries that joined the EU in the enlargement rounds of 2004 and 2007 (see chart 2). The fastest to accede were Estonia and Latvia at around eight years and the slowest, Cyprus and Malta at 14 years. Whereas the EU enlargement rounds of 2004 and 2007 considerably changed the European Union’s profile, Croatia’s accession will only have marginal effects. Croatia will be the 9 th smallest country in the EU by GDP size at 0.34% of the total. Its population of 4.4 million will account for 0.87% (8 th smallest). Its GDP per capita (in PPS) in 2011 amounted to 61% of the EU27 average (55% of EU15, see chart 1). Economic headwinds cloud EU entry Croatia’s integration into the EU and its institutions is a huge step for the Western Balkan country that endured more than four years of war before gaining independence from former Yugoslavia in 1995. Croatia’s economy will – at least in the medium term – benefit from full access to EU markets and net revenues from the EU budget. 0 2 4 6 8 10 12 14 16 EE LV LT CZ HU PL RO SK HR BG SI CY MT Note: all new member states joined the EU in 2004 (except for Bulgaria and Romania in 2007, Croatia in July 2013) Years from EU application to accession Sources: EC, DB Research Application time in the EU mid - range 2 85 90 95 100 105 110 115 120 2007 2008 2009 2010 2011 2012 EU - 27 CEE IT HU HR PL RS SI Sources: IMF, DB Research Strongly hit by the crisis 3 Real GDP, index (2007=100) 17.5 10.6 8.0 5.8 18.2 13.1 26.8 IT DE SI AT Other EU BA Rest of the world Exports to the EU dominate 4 % of total (average 2008 - 12) Sources: IMF, DB Research - 15% - 10% - 5% 0% 5% 10% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Private consumption Government consumption Gross fixed capital formation Changes in inventories Net exports GDP % yoy Sources: IMF DOTS, DB Research Drop in domestic demand weighs on economic growth 5 Croatia facing challenges on the EU’s doorstep 3 | June 18, 2013 Research Briefing However, the short-term economic outlook is bleak. A combination of an unfavourable external environment as well as subdued domestic demand have taken a serious toll on the Croatian economy. The credit-driven economic boom of the years preceding the global financial crisis turned into a bust when foreign financial flows declined sharply. Croatia is one of the few countries which have not seen any year of positive GDP growth since 2008 (see chart 3). From 2008 to 2012, the economy shrank by a whopping 11%. Real GDP dipped back into recession in 2012, after zero growth in 2011. Also for 2013 we expect a recession, before the economy will gradually recover in 2014. Croatia has been heavily exposed to the eurozone debt crisis, with about 60% of exports going to the currency bloc and almost 20% to Italy alone (see chart 4). The banking sector is foreign-dominated, with Italian parent banks holding almost half of the total assets. The Croatian currency, the kuna, is informally pegged to the euro. With around 70% of loans and above 60% of deposits denominated in or linked to foreign currency (EIU, 2013), the central bank is strongly committed to the peg, which limits the authorities’ scope to react to the crisis via monetary and FX rate policies. The slowdown in export growth, foreign investment and credit has permeated the Croatian economy (see charts 5 and 6). Non-performing loans (NPLs) stood above 14% of total loans in March 2013. Unemployment increased by more than 7pp from the beginning of the financial crisis in 2007/8 to 20.9% of the labour force in April 2013 (see chart 7). Youth unemployment is estimated at above 40%. For an emerging economy, public debt is high at close to 60% of GDP and is predicted to increase further over the next few years, given a fiscal deficit of above 3% of GDP and subdued economic growth prospects compared with the pre-crisis years (see chart 8). The combination of low growth, structural imbalances and weak public and external finances led to a downgrade of Croatia’s sovereign rating below investment grade by two of the three major rating agencies, increasing the country’s external refinancing costs. Nevertheless, Croatia has managed to avoid an IMF programme so far. Beside the damaging impact of the eurozone crisis, structural problems lie at the root of Croatia’s economic woes. These include a low diversification of Croatia’s exports, which mainly rely on shipyards as well as tourism, two strongly pro- cyclical sectors. The international competitiveness of Croatia’s economy is low, reflecting in particular rigidities in the labour market, an overblown public sector, and a weak business climate. This is reflected in low rankings in the World Bank’s Doing Business (DB) and the Global Competitive Index (GCI) compared with peers (see charts 9 and 10). Among the Doing Business indicators, scores for “construction permits” and “protection of investors” are particularly low. Labour costs are relatively high compared to productivity. 1 According to the European Commission, the shadow economy could account for up to 40% of 1 See IMF (2012): “The Republic of Croatia: Staff Report for the 2012 Article IV Consultation”; page 13f. 10 12 14 16 18 20 22 0 2 4 6 8 10 12 14 16 2007 2008 2009 2010 2011 2012 Non - performing loans, % of total loans (left) Unemployment, % of total labour force (right) Tight credit conditions, high unemployment affect demand 7 Sources: IMF IFS, Croatian Bureau of Statistics, DB Research - 10% - 5% 0% 5% 10% 15% 20% 25% 30% 60 65 70 75 80 85 90 95 100 105 Q1 07 Q3 07 Q1 08 Q3 08 Q1 09 Q3 09 Q1 10 Q3 10 Q1 11 Q3 11 Q1 12 Q3 12 Foreign claims, USD bn (left) Domestic bank credit to the private sector, % yoy (right) Sources: BIS, IMF, DB Research Dry - out of foreign funds and lending 6 0 10 20 30 40 50 60 - 6 - 5 - 4 - 3 - 2 - 1 0 07 08 09 10 11 12 Public debt (right) Fiscal balance (left) Primary balance (left) Weak public finances 8 % of GDP Sources: EC, DB Research 0 20 40 60 80 100 EE EU27* CZ PL SI HU BG SK RO HR RS Global Competitiveness Index 9 Ranking out of 144 (2012 - 13) * EU27: median Sources: World Economic Forum, DB Research 0 20 40 60 80 100 EE EU27* SI SK HU PL CZ BG RO HR RS Ease of Doing Business 10 Ranking out of 184 (2013) * EU27: median Sources: World Bank, DB Research Croatia facing challenges on the EU’s doorstep 4 | June 18, 2013 Research Briefing GDP. 2 While the government has started to address several of these issues in recent years, more and faster progress is necessary in particular regarding the inflexible labour market, privatisation of state-owned enterprises, reforms of the pension system and strengthening the business/investment climate. Benefits of EU integration As mentioned above, further structural reforms would be necessary for Croatia to reap the fruits of economic and institutional integration into the EU. But some of the financial advantages of EU membership will materialise quite soon. Upon accession, Croatia will, for example, gain access to the Cohesion Fund, the Structural Fund and the European Fisheries Fund. The total sum of approved funds for Croatia amounts to EUR 655 m (around 1.5% of GDP) for the second half of 2013 (see chart 12). 3 As a new member, Croatia will also receive funds from the Transitional Facility (EUR 29 m in 2013) in order to speed and smooth the journey from non-member to member as well as from the Cash Flow Strengthening Facility (EUR 75 m in 2013). The fact that Croatia will share its border with non-EU countries means that it will receive another EUR 40 m in 2013 in order to prepare its border for future entry into the Schengen area. On the other hand, Croatia will contribute an estimated EUR 212 m to the EU this year. The net receipts thus amount to 1% of GDP in 2013. Given that the EU’s Multiannual Financial Framework (MFF) still needs to be approved by the European Parliament, estimates of receipts for 2014-2020 are only vague. But in the latest draft, total funds earmarked for Croatia were around EUR 13.7 bn. 4 Croatia’s payments will be much lower, by comparison, and are currently approximated by around EUR 4 bn. Thus, net receipts would amount to EUR 1.39 bn on average per year (2.7% of 2013 forecasted GDP). This is comparable to the net receipts of Lithuania and Slovakia. Croatia’s economic success prior to the crisis was quite dependent on capital inflows, with net FDI covering a large share of the current account deficit in 2003-07, and abundant cross-border bank lending on top of that (see charts 6, 13 and 14). But capital inflows to the CEE region declined sharply when the global financial crisis erupted, and have remained subdued since. Moreover, investors and foreign parent banks have become more discriminating within the region, focusing more on key markets that are considered economically sound and profitable. Given the ongoing deleveraging in the banking industry in Western Europe as well as regulatory changes, foreign bank lending in Croatia is unlikely to pick up to pre-crisis levels over the next few years. That is why Croatia will need to rely even more on foreign direct investment. Croatia’s EU membership is an important factor in this respect, helping to bolster investor confidence. According to the German Chamber of Commerce’s Economic Survey for CEE 2012, EU membership remains one of the key factors that determine the attractiveness of CEE countries amongst investors. 5 Overall, Croatia can be expected to profit considerably from its EU accession, not only politically but also in economic terms. Being part of an economic union, however, is also linked to new challenges. By entering the EU, Croatia becomes subject to the EU’s Excessive Deficit Procedure (EDP) which is triggered once a member state exceeds the 3% of GDP deficit and 60% of GDP public debt ceilings defined in the Stability and Growth Pact. Possible sanctions include lifting the suspension of commitments from the EU’s Cohesion Fund. Given Croatia’s weak fiscal standing, it is more than likely that its EU entry will be accompanied by the EDP. However, both increased market competition and 2 European Commission (2013): “Assessment of the 2013 economic programme for Croatia”. 3 European Commission (2013): “2013 budget and MFF update to cover Croatia's entry to the EU”. 4 European Commission (2013): “Croatia and EU – prejudices and realities”. 5 AHK (2012): AHK-Konjunkturumfrage MOE 2012. 0.64 0.32 0.16 0.1 0.09 0.45 0 100 200 300 400 500 600 700 Receipts Payments Structural fund Cohesion fund Cash flow strengthening facility Funds for competitiveness Schengen facility Transitional facility Other approved funds EU payments Croatia's financial EU benefits in 2013 12 EUR m, % of GDP Sources: European Commission, DB Research 0.03 0.06 0 5 10 15 20 25 30 35 BG RO PL HU SK EE HR SI EU27 DE Wages, EUR per hour Relatively high wages 11 Sources: Eurostat, DB Research 29.3 14.1 13.8 8.7 5.5 4.2 3.3 3.1 8.9 8.9 AT HU DE NL LU SI GB IT Other EU Rest of the world Inward FDI largely from EU 13 % of total (2011) Sources: IMF Coordinated Direct Investment Survey, DB Research Croatia facing challenges on the EU’s doorstep 5 | June 18, 2013 Research Briefing fiscal supervision, while at first potentially generating economic costs, should in the medium term help to boost competitiveness and fiscal discipline, thereby supporting more sustainable economic development. Euro adoption not before the end of the decade With its entry into the European Union, Croatia, like all EU member states 6 , agrees to also join the euro. However, there is no predefined timeframe for adopting the euro, as it depends on the fulfilment of a list of convergence criteria laid down in the Maastricht Treaty (see table 15) and therefore not only on the economic conditions but also the political willingness to comply with the criteria and to adopt the euro. As demonstrated by previous EU enlargements in 2004 and 2007, it is likely to take several years until Croatia embarks on the final stage of European integration and eventually replaces its kuna with the euro. So far, 5 of the 12 new member states have joined the common currency. Slovenia was the fastest, with only three years from EU entry in 2004 to euro adoption in 2007. Cyprus and Malta joined the currency bloc in 2008, Slovakia in 2009, and Estonia in 2011. The EC and the ECB recently gave the go-ahead for Latvia to join in 2014 and Lithuania plans to follow in 2015 – even though in both countries polls suggest that euro adoption currently is not backed by a majority of the population. Poland, the Czech Republic, Hungary, Romania and Bulgaria have refrained from committing to a joining date. Currently, Croatia only meets one of five criteria fully (see table 16). At 5.5% the 12-month average of the long-term interest rate in May is just above the allowed maximum. Even though the kuna/euro exchange rate has not fluctuated more than +/-15% around the two-year mean (7.51 HKR/EUR), Croatia still needs to officially join ERM II for a two-year period before it can adopt the euro. The inflation criterion was fulfilled in previous years but a recent hike in Croatia’s price levels in late 2012 sent the inflation rate above the allowed range. Officially, government debt amounted to 53.7% of GDP in 2012, below the 60% Maastricht limit. However, against the background of current economic weaknesses and low revenues, public debt is expected to breach 60% of GDP next year. In addition, this measure does not include around 15% of publicly guaranteed debt, which would drive total debt even higher. The fiscal deficit has breached the 3% of GDP limit every year since 2009 and is expected to stay above the limit in the foreseeable future. All in all, euro adoption is unlikely to occur before 2020 at the earliest. Kevin Koerner (+49 69 910-31718, kevin.koerner@db.com) Tilman Bletzinger 6 Exemptions are granted to the UK and Denmark. Country key 17 Austria AT Bosnia and Herzegovina BA Bulgaria BG Croatia HR Czech Republic CZ Estonia EE Germany DE Hungary HU Italy IT Latvia LV Lithuania LT Luxemburg LU Netherlands NL Poland PL Romania RO Serbia RS Slovakia SK Slovenia SI Sweden SE United Kingdom GB Source: DB Research Croatia and the e uro 16 Criterion Latest reference* Croatia Inflation 2. 6 % 3. 9 % Interest rate 5.4 % 5 .5 % Exchange rate ERM II no Public debt 60% 53.7 Public deficit 3% 3.8 % *P artly own calculations , May 2013 data Sources: EC, Eurostat, Datastream, DB Research Convergence criteria to join the euro area 15 As all EU c ountries that prepare th emselves for joining the eurozone, also Croatia will also have to fulfil five Maastricht criteria that serve as preconditions for the single currency: — The 12 - month average of CPI must be at most 1.5 percentage points above the average of the three lowest CPI values in the EU. — The long - term interest rate must be at most 2 percen tage points above the average of the three lowest CPI values in the EU. — Croatia has to join ERM II and keep its Euro exchange rate within +/ - 15% of a central rate, which is not allowed to be changed, for two years. — The government debt to GDP ratio must be at most 60 % . — The fiscal deficit must be at most 3% of GDP. Source: European Commission - 1 - 1 0 1 1 2 2 3 3 4 4 5 2005 2006 2007 2008 2009 2010 2011 2012 AT NL DE HU LU FR IT Other Sources: Croatian Ministry of Finance, DB Research Strong drop in FDI inflows since the global crisis 14 EUR bn, by origin Emerging m arkets publications Our publications can be accessed, free of charge, on our website www.dbresearch.com You can also register there to receive our publications regularly by E - mail. Ordering address for the print version: Deutsche Bank Research Marketing 60262 Frankfurt am Mai n Fax: +49 69 910 - 31877 E - Mail: marketing.dbr@db.com Available faster by E - mail: marketing.dbr@db.com  ASEAN Economic Community (AEC): A potential game changer for ASEAN countries .............. June 14 , 201 3 Current Issues  German industry : China market growing moderately ................................ .... April 10, 201 3 Research Briefing  Emerging markets : Wh o is vulnerable to overheating? ................................ . 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