External imbalances in Croatia - A matter of concern?

Since the early 1990s Croatia has managed a rather successful transition process with solid growth, low inflation and exchange rate stability. Better integration into international financial markets, capital account liberalisation and banking sector reform have facilitated access to foreign financing and opened the country to strong and persistent capital inflows. A significant increase in Croatia's external debt over the last few years, and a recent widening of the current account deficit, have attracted the attention of policymakers and external observers alike. This Country Focus argues that a rise in external indebtedness has made Croatia more vulnerable to potential shocks, but also finds that sizeable foreign assets of the banking system and evidence about the existence of unrecorded foreign exchange holdings by the private non-banking sector mitigate external risks. Current account deficits have been driven by strong investment growth rather than a decline in domestic savings, thus providing some reassurance on sustainability issues. The Country Focus concludes that, in the specific setting of Croatia, further fiscal consolidation remains a key instrument to address external vulnerabilities and allow for a much needed further expansion of private-sector activities. In this context, deeper structural reforms could trigger a stronger supply response, raise potential output and improve competitiveness on a broader front.