July 2010 Regular Economic Report CROATIA Supporting Recovery

Bottoming up continues; fragile and slower than expected  Still weak domestic demand; with strong investment drop  Net exports remained the key contributor to growth  Outlook for 2010 is weaker than expected (-1 percent compared to expected zero growth); with downward risks due to rising fiscal concerns and sluggish EU recovery Source: CROSTAT Volume of Construction Works, 2005=100 Total industrial production and manufacturing, 2005=100, seasonally adjusted, 3MA

Financial linkages and concerns about debt dynamics call for faster safeguarding policies Source: World Bank Global Prospect Group, staff calculations.  Interest rates remain volatile as recovery takes hold and risk-aversion gets heightened due to concerns about European bank-exposures to bad debt, and an increase in funding demand  Faster efforts in safeguarding the recovery through shoring up fiscal sustainability and creating fiscal space to support private sector growth Capital inflows to Eastern Europe, USD billions Asset class performance in the EU10 region, percent change Source: Reuters, Bloomberg, World Bank staff calculations

Unemployment on decline in 2011  Increase in unemployment still less than in most EU countries, as the informal sector cushioned the adverse employment impact of the crisis (likely shift towards grey economy more than 50% compared to Q108);  Continued pressure on the private sector to improve its profitability and restore balance sheets  (Potential) restructuring of the public sector Difference between ILO and Registered Employment, in thousands  Wage adjustments in private sector continues

Financial sector stability key to recovery.. Private sector credit growth, y/y, in percent  Credit activity to corporate sector slightly recovered (loans rescheduling in construction and real estate sectors)  Interest rates decline due to ample liquidity and low demand  Currency risk heightened with FX placements rising back to almost two-thirds of the total and FX deposits to near 80 percent.  Still some uncertainties on the level of potential losses hidden in banks' balance sheets Share of NPLs in total loans

..while credible fiscal response is a precondition  Revenue shortfall due to early withdrawal of stimulus measures and slower than expected growth  Rebalancing through expenditure cuts to help reduce borrowing requirements and help improve sustainability  Without aging costs and contingent liabilities, primary balance to improve by over two percent of GDP to stabilize public debt at 2009 level General Government Deficit, % of GDPPublic debt, in HRK billion

Policy response - determined implementation of the Economy Recovery Program  ERP presents a solid basis for safeguarding recovery.  This would require structural changes in public finances, social sectors, education, innovation, and business climate.  However, slower growth in Croatia than in the best performing EU10 countries points to a lack of confidence in the recovery.  This reinforces the need for the early and determined implementation of the ERP.