Mirogoj Cemetery on the wooded hills north of Zagreb tells much about the history of Croatia. Under green-tiled cupolas and sculptured stone arcades lie the crypts of Croats and Serbs, Bosnians and Slovenes, Austrians, Germans and Jews who coexisted peacefully during the Austro-Hungarian Empire, a half-century experiment in European unity that ended in the ashes of World War I. In the newer section of Mirogoj, however, the graves belong almost exclusively to Croats, many of them victims of the fratricidal 1991'95 civil war in the Balkans. That conflict enabled Croatia to gain independence from the former Yugoslavia, but it exacted a heavy human and economic toll and saddled the country with a share of blame for brutality not witnessed in Europe since World War II.
The Republic of Croatia has come a long way in the decade since. Tourism is thriving again as peace encourages Western European visitors to return. A consumer boom is visible in the new high-rises and malls and in the traffic-clogged streets of Zagreb and other major cities. Parliamentary democracy is strong, underscored by the relatively harmonious cooperation between the governing center-right coalition, led by Prime Minister Ivo Sanader, and its center-left opposition, led by President Stjepan Mesi´c.
Yet Croatia’s recent history continues to cloud the country’s prospects. In March the European Union indefinitely postponed membership negotiations with Zagreb to protest the country’s failure to hand over its most notorious alleged war criminal, retired general Ante Gotovina, for prosecution at the United Nations International Criminal Tribunal for the former Yugoslavia. As that decision makes clear, Croatia needs to resolve its turbulent past and reconcile itself with its neighbors to secure the promise of future prosperity in the EU.
“Our negotiations to enter the EU won’t be the same as for those before us, like the Czech Republic, Slovakia, Hungary and Poland,” acknowledges Vladimir Drobnjak, the ambassador who will be Zagreb’s chief negotiator in the membership talks. “We are carrying some very special baggage -- war crimes and refugees, a devastated economy, difficult relations with neighbors.” During the war more than 200,000 ethnic Serbs and Muslims were forced to flee Croatia for neighboring Serbia and Bosnia-Herzegovina, and their claims over property left behind are still unresolved. Bosnian officials fear Zagreb might in turn be tempted to make territorial claims in the future on behalf of the sizable minority of Croats living in Bosnia.
Prime Minister Sanader insists that the war’s legacy, and even the flap over Gotovina, won’t derail Croatia’s objective of joining the EU by the end of 2008. He has sought to reduce cross-border tensions to advance his country’s EU candidacy, vowing that Croatia won’t covet Bosnian territory, and last November he became the first Croatian leader to visit Belgrade, the Serbian capital, since the end of the war.
“Everybody realizes that EU accession is of utmost importance,” Sanader tells Institutional Investor in an interview (see box, opposite). This view is echoed by President Mesi´c, who in January won a resounding reelection to the largely ceremonial post as the candidate of a coalition of center-left parties dominated by the Social Democratic Party. The joint stance of government and opposition reflects a strong national consensus to integrate with the European mainstream and end Croatia’s postcivil war status as a political pariah. As Mesi´c puts it, “Today both major parties are competing for the political center.”
The government claims it doesn’t know Gotovina’s whereabouts and says he is hiding outside the country. The U.N. tribunal and, crucially, the EU believe otherwise. “Ante Gotovina remains within reach of the Croatian authorities, and until such time as he is brought to the Hague, it cannot be said that Croatia is cooperating fully with the international tribunal,” wrote chief prosecutor Carla del Ponte in a March 8 letter to EU foreign ministers.
Nobody knows how long the postponement of EU membership negotiations will last. “I really hope we are not talking about many months,” says Krisztina Nagy, spokesperson for Olli Rehn, the EU commissioner in charge of enlargement. “But I am not aware of any new information that would make it possible for negotiations to start.”
Economically, the country is well prepared for EU membership. After its neighbor Slovenia, Croatia boasts the strongest industrial base in the former Yugoslavia and has an average income roughly one third above the federation average. The economy has grown strongly since the war, with GDP expanding by 3.7 percent last year. Per capita GDP stands at about E10,300 ($13,470) on a purchasing-power-parity basis, just 2.8 percent below Poland’s and nearly 50 percent higher than Bulgaria’s and Romania’s, countires that have been approved to join the EU in 2007. These economic credentials have helped Croatia attract more foreign direct investment -- $1,857 on a per capita basis -- than Slovenia or Poland.
Croatia has also been swift to comply with the EU’s economic criteria for membership. Over the past decade the financial system has been rescued from insolvency and modernized by foreign banks that now hold more than 90 percent of banking assets. Industry has been largely privatized, with most of the remaining state-controlled dinosaurs -- shipbuilding, oil and electricity companies among them -- scheduled for sale this year and next. This should bring the private sector’s share of GDP -- currently about 60 percent -- closer to the 75 to 80 percent average of recent EU accession countries.
“The economic changes are dramatic,” says Sanader. “We are a functioning market economy. Our credit rating has improved.” In December, Standard & Poor’s raised Croatia’s credit rating to triple-B, one notch higher than its rating for Bulgaria, which completed negotiations with the EU in December.
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RESTRUCTURING THE ECONOMY HAS BEEN PAINFUL, however, swelling the jobless rate to 18 percent. “Our biggest economic problem is unemployment,” says President Mesi´c. “Privatization was supposed to foster economic growth that would create more jobs, but in fact large enterprises have been devastated, and they haven’t been replaced by enough small and medium businesses.” Although unemployment has increased political tensions, the opposition shows no inclination to derail the government’s economic policy and add another obstacle to EU accession talks.
Tourism is helping to pick up the slack now that peace has enabled Croatia to exploit its coastal beauty and historical treasures once again (see box, page 80). Last year foreign visitors totaled 9.4 million, more than double the country’s 4.5 million population. Tourism revenues hit E4.9 billion ($6.7 billion), up sharply from E3.6 billion in 2002 and amounting to almost 20 percent of the country’s E26.1 billion GDP.
The economy also faces other challenges, including a persistently high budget deficit fueled by social welfare spending and a heavy external debt burden stoked by a consumption boom and a lag in exports.
Sanader vows to tackle these problems, promising greater spending restraint to cut the deficit and the elimination of red tape to foster business and reduce corruption. His reforming instincts are hampered, though, by the fact that his party controls only 66 of the 151 seats in Parliament. “We would be doing more -- and more quickly -- to advance fiscal and economic reforms” if the government had a majority, he acknowledges, citing the need for lower taxes and speedier privatization.
Croatia’s political system has gone through a considerable transformation, and moderation, since the civil war. Though founded in 1989, Sanader’s HDZ, or Croatian Democratic Union, traces its roots to the Usta(breve)sa, the ultrarightist nationalists who were henchmen to the Nazis during World War II. Under late president Franjo Tudjman, the party led Croatia to independence in 1995 but also ruled in a corrupt and authoritarian manner. Tudjman protected army officers accused of brutality, including Gotovina, who has been indicted for allegedly ordering the massacre of 150 Serbs and the expulsion of 150,000 others from territory recaptured in the war.
After Tudjman’s death from stomach cancer in December 1999, the party fell into disarray, winning only 24 percent of the vote in the January 2000 parliamentary elections. HDZ members saw the poor showing as a rejection of ultranationalist, right-wing policies and turned for leadership to Sanader, who had kept a low profile during the 1990s but remained close to the levers of power. He served as deputy foreign minister and head of Tudjman’s office during the war, yet he was unsullied by corruption scandals or charges of protecting war criminals.
Sanader has demonstrated considerable political talents in transforming the HDZ into a centrist party and guiding it to the surprise election victory in 2003 that made him prime minister. “He has had great success in leading the process to EU accession and at the same time educating his followers on the need to join Europe,” says Nenad Zako(breve)sek, a political scientist at Zagreb University.
The prime minister also scores well among compatriots and outsiders for his fluency in several languages, including English, French, German and Italian, as well as for his rugged good looks and well-tailored suits. “Finally, a politician whose sleeves don’t cover his hands,” quips one European ambassador.
Sanader wins further praise for his openness to criticism by international agencies and his willingness to pursue the reforms they urge. When the government disclosed in mid-2004 that its budget deficit the previous year had hit 6.3 percent of GDP, far above its 4.5 percent target, the International Monetary Fund upbraided Croatian officials and demanded steps to improve fiscal transparency, including tighter monitoring of state-owned enterprises and greater openness in the privatization process. Since then the government has required the Ministry of Finance to supervise more closely the borrowing and spending of the 23 largest state enterprises. Moreover, when new privatizations are announced, the tenders are communicated widely through the local media and the Web site of the government’s Croatian Privatization Fund. Athanasios Vamvakidis, the IMF resident representative in Zagreb, says, “The authorities have done almost everything asked of them.”
Croatia will need all the good advice it can get to overcome some daunting economic challenges. The most pressing is its large external debt, which peaked at 85 percent of GDP in 2003 and still remains a lofty 75 percent, a level the IMF regards as the upper limit of sustainability.
The surge in debt partly reflects a drop in manufactured exports. The war closed off Croatia’s biggest market, the other countries of the former Yugoslavia, and in the aftermath high labor costs and a strong kuna (the local currency) have combined to undermine competitiveness and prevent a revival of manufacturing. The sector generated 20 percent of the country’s GDP last year, down from more than 25 percent in 1994. “Investment in manufacturing just isn’t on the horizon,” says Mark Gero, president of the American Chamber of Commerce in Croatia.
External debt has also been fueled by the generous lending of the country’s foreign-owned banks, which are financing a consumer boom. The banks have ready access to euros and prefer lending them to Croatian consumers rather than to businesses. “With retail lending, especially mortgages, we have far better collateralized exposure than with small and medium businesses,” says Milivoj Goldstajn, a board member with Zagrebacka banka, the country’s largest bank, which is owned by UniCredito Italiano.
The authorities remain worried, however, about risks inherent in the lending boom. “If there is a large devaluation, borrowers will then default on their [euro-denominated] debt,” says Boris Vujcic, deputy governor of the Croatian National Bank. That risk, he adds, helps explain why commercial banks charge rates of up to 10 percent for euro-denominated consumer loans and more than 7 percent for business loans, even though macroeconomic stability has reduced inflation to just 2 percent.
Croatia enjoys a bigger banking system than many of the new EU members in Eastern Europe, with bank assets amounting to 112 percent of GDP. Italian and Austrian banks dominate the financial sector. UniCredito, through Zagrebacka banka, claims a 26 percent share of total banking assets. Close on its heels is Intesa-BCI, which has 20 percent of banking assets, thanks to its purchase of Privedna banka Zagreb. The No. 3 bank, Erste Bank Croatia, a subsidiary of Austria’s Erste Bank, has a 10 percent share. For all of them, consumer loans have been the most profitable and fastest-growing part of their business and are likely to remain so for the next few years.
Fully 70 percent of lending is linked to or made in foreign currencies, primarily the euro. The boom in retail lending in particular has fueled the growth of external debt. Consumer loans account for half of all bank lending. Especially popular are loans for cars and durable household goods, which carry an 8 to 10 percent annual interest rate in euros. Residential mortgages are increasingly available, at an average annual interest rate of 7 percent in euros.
“Croats have a real eagerness to consume when given the instruments to do so,” says Sava Dalbokov, head of investment banking at Erste Bank Croatia.
At first glance, the reluctance of Croats to lend or save in kuna seems puzzling. Inflation has stayed below 2.5 percent over the past three years, and with the Croatian National Bank pursuing a currency target as its main policy, the kuna has traded well within a band of plus-or-minus 15 percent against the euro for the past decade -- fluctuating only between 7.3 and 7.5 kuna to the euro during the past year. “We act as a quasicurrency board,” says deputy governor Vujcic. “We don’t fix the exchange rate but rather tightly manage it.”
In spite of the kuna’s stability, however, past episodes of hyperinflation -- particularly during the civil war -- have driven Croats into deutsche marks, dollars and, lately, euros. “Once a country reaches such a high level of currency substitution, it’s almost impossible to fully reverse the process, even after a long period of stabilization,” says Vujcic.
This “euroization” makes it virtually impossible for the central bank to control the economy with traditional monetary policy tools, such as domestic interest rates. So the bank has turned to administrative measures. In 2003 it introduced an implicit tax on credit growth. If a bank’s loan portfolio expands by more than 16 percent in a year, the central bank requires it to spend an amount equivalent to its excess lending on central bank bills bearing interest of only 0.5 percent. The authorities also require banks to keep 35 percent of their assets in liquid foreign exchange for up to three months. Then in 2004 implicit capital controls were introduced. Banks were required to deposit 30 percent of new foreign borrowings with the central bank, again at 0.5 percent interest.
The measures have worked. Credit growth slowed from an annual rate of 30 percent in 2002 to 15 percent in 2004. Banks aren’t complaining -- at least not yet. Profit margins for the Austrian and Italian banks here are still substantially higher than in their home markets, says Stefan Maxian, a Vienna-based banking analyst who covers the region for Raiffeisen Centrobank.
“These requirements have forced us to keep a higher balance sheet than we might want, but so far our bank has managed pretty well,” says Erste’s Dalbokov. The lending controls helped slow economic growth to 3.7 percent last year from 4.3 percent in 2003 and reduced the current-account deficit to 5.8 percent of GDP from 7.2 percent in 2003. “The moderation in growth has been gradual, which is ideal,” says Goran (breve)Saravanja, the head economist in Zagreb for CA IB, a Vienna-based investment bank.
Fiscal policy poses an equally important challenge. The budget deficit has risen from less than 2 percent in 1999 to 6.3 percent last year because of increased spending on health care, unemployment insurance and payments to war veterans. The deficit spending, in turn, has aggravated the country’s current-account and external debt woes.
“We have to keep the fiscal deficit down and reduce the government’s contribution to the growth of external debt,” says Deputy Finance Minister Martina Dali´c. That won’t be easy. Dali´c estimates that truly discretionary spending makes up only about 15 percent of the budget. Almost a third of spending goes to pension payments, which average only 42 percent of a retiree’s last salary and are almost untouchable politically. The budget must also accommodate the demands of veterans from the 1990s war, who account for nearly a third of the country’s unemployed and constitute a powerful constituency for maintaining jobless benefits. “Society feels it owes these people a reasonable level of support,” says Dali´c.
International agencies insist there is ample room for budgetary savings. The IMF, for example, has suggested that the government curb health spending -- which accounts for more than 9 percent of GDP -- by requiring patients to pick up a bigger share of the costs. (Two thirds of Croats are exempt from making health care co-payments.)
The World Bank believes better debt management could provide additional savings, pointing out that in late 2003 some 20 percent of the central government’s external debt was in Japanese yen -- a currency that was strengthening against the euro. The Finance Ministry heeded the advice, trimming yen exposure to 15 percent of government debt. “We are also trying to shift our exposure more toward the domestic capital market,” says Hrovje Radovani´c, head of public debt and cash management at the Ministry.
In a significant test of this strategy, the government in March issued a five-year, kuna-denominated Treasury bill worth approximately E400 million, with an annual yield of 6.75 percent. The lead managers were three of the top local banks -- Privredna banka Zagreb, Raiffeisen Bank Austria d.d. Zagreb and Zagrebacka banka. According to Ivo (breve)Sulenta, deputy chairman of the Securities Commission, the bill’s success was no surprise: “There is enough of a local capital market now between pension funds, mutual funds, banks and insurance companies.”
The growth of kuna-denominated pension and mutual funds will gradually increase the government’s ability to borrow in local currency, (breve)Sulenta contends. But nobody expects the kuna to challenge the euro’s predominance. “Within ten years the euro will probably be official tender in Croatia, so for most people we are in a transition period anyway,” says CA IB economist (breve)Saravanja.
Besides making cuts in public services and better managing debt, the government could achieve even more budget savings by slashing subsidies to state-owned companies and accelerating privatization. Shipbuilding in particular has been singled out by the European Bank for Reconstruction and Development as a sector the state should relinquish. “We have been looking at the balance sheets of some of these shipyards, and the only reason they are still alive is that they are subsidized by the state,” says Maria Vagliasindi, a London-based economist who covers Croatia for the European Bank for Reconstruction and Development.
Indeed, little Croatia ranks No. 1 in Europe in terms of deadweight tonnage on order -- 75 ships totaling 2.9 million tons and worth $2.2 billion are due to be delivered by 2008. The country’s shipyards have raised productivity, slashing their labor force to 12,928 last year from about 27,000 in 1990 while maintaining production. For all those improvements, however, Croatia can’t keep pace with lower-cost shipbuilders in China, Japan and South Korea that account for 85 percent of deadweight tonnage on order in the world over the next three years. The shipyards generate a loss of about 10 percent on every vessel they sell, says Mladen ´Corluka, commercial director of the Croatian Shipbuilding Corp., the sector’s lobby association. Public subsidies cover the gap, but the government is running out of patience and plans to privatize the shipyards by 2007.
Officials are pushing the five main shipyards to merge into three before they are privatized by 2007. “We see one shipyard -- Uljanik -- that is ready for privatization this year and can show the others what has to be done,” says Ante Babi´c, head of economic planning in the prime minister’s office.
Located in Pula on the Adriatic coast, Uljanik specializes in car carriers, a segment where Croatia can still compete against Asian shipyards. Last year Uljanik delivered five ships worth a total of $161 million -- up from four sold for $135 million in 2003; ´Corluka says it is on the cusp of profitability. He believes it will take a decade, however, before the other shipyards are ready for privatization and warns that haste would threaten the seafaring soul of the nation.
And so the government faces a test of its resolve. Its willingness to forge ahead with the most controversial privatizations and to abide by EU demands to hand over suspected war criminals will determine whether Croatia is ready to join the mainstream of Europe. Supporters of membership believe the country has traveled too far from the war era to turn back now.
“The prospect of EU membership has essentially changed public discourse in Croatia,” says Vladimir Gligorov, staff economist at the Vienna Institute for International Economic Studies. “Everything, even national identity, is now seen within that context.”
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