Croatia became the 28th member of the European Union at midnight on Sunday, passing a milestone in its recovery from war but anxious over the troubled state of its economy and the bloc it is joining.

It  is also the first expansion of the EU eastwards since 2007, when Romania and Bulgaria joined, and the “Big Bang” enlargement of 2004 when ten new members came aboard. The global economic crisis has since posed unprecedented challenges to the unity of the bloc, undermining popular support and fueling doubts over the wisdom of further expansion to the former Yugoslavia.

Croatia Benefits

So far Croatia stands to get around $15bn of EU financing, albeit with conditions, and will also get access to larger EU markets, with the prospect of foreign direct investment.

The EU for its part gets more stability in the Balkans, a slightly larger market, and less hassle at the borders.

Critics in Croatia

On the flipside, critics in Croatia argue they are joining a bloc whose own economy is pretty fragile, and some fear the EU’s market will be too competitive.

Opponents in the EU say Croatia’s corruption and its economic weakness pose the biggest threats, and any mistakes could jeopardize the EU ambitions of acquiring other Balkan states and places like Turkey.

Current Account deficit shrinks in Q1 on lower merchandise trade gap

The EU is mired in its own economic woes, which have created internal divisions and undermined popular support for the union. A question has been raised about whether or not this is the right time to join hands with the bloc. Hypo Alpe Adria Bank Economic Research has highlighted key economic activities of Croatia.

The lower C/A deficit reading amid goods trade gap is largely a by-product of import demand weakness as exports also took a hit from shipyard restructuring and lower food dispatches (notably sugar). Services surplus increased thanks to higher tourism receipts, helped by the early Easter effect, although stronger competition from austerity tourism destinations (e.g. Greece witnessing 20%+ increase in foreign overnights) and bad weather have suggested the opposite. Last but not least, lower income deficit on smaller debt service courtesy of globally-induced decline in risk premiums charged for investment repayment. In relation to GDP, the C/A position swung into its first ever surplus (0.6% of GDP vs -0.03% at the end of the last year).

Croatia Economy

Stronger portfolio inflows compensate for private de-leveraging

Despite deteriorating banks’ net external position (down by EUR478m or 1.1% of GDP in Q1) and momentarily non-existent portfolio inflows, C/A funding will be bolstered in the subsequent quarter by the sovereign USD1.5bn bond issue (2.7% of GDP). The CNB data has confirmed that the de leveraging process is concentrated in the banking sector as its external debt (in particular long-term debt) fell by EUR228m in 1Q13. Meanwhile, FDI improved somewhat notwithstanding lower non-residents’ retained profits and traditional decision-making deadlock before the local elections (scheduled in May). Reflecting the above mentioned developments, the year-to-date BoP dynamics are consistent with the ongoing gradual build-up in FC reserves, which together with the forthcoming larger FX-linked domestic bond issuance is kuna-supportive.

Croatia Economy

Outlook and policy implications

Notwithstanding export-driven trade gap widening amid CEFTA agreement termination and fledgling demand from the key trade partners in 2H13,  expect higher service surplus and transfers to ensure the C/A stays in surplus. Though the basic balance (C/A+FDI) surplus (2-3pp of GDP) reduces the need for new debt, the focus stays on 35%+/GDP short-term roll-over needs and the public sector’s affordable funding abroad now that the normalization of core interest rates and risk premiums is bound to start. This translates into a more cautious MinFin’s stance on interest rates and duration while eyeing prefinance in intl. markets in Q4 ahead of hefty maturities in 4M14 (EUR650m FX-linked bond, EUR500m Eurobond, HRK6.9bn T-bills). For the moment, the CNB stays on hold as it saw a tentative private credit recovery, and tighter risk provisioning rules imply any CNB easing is impending on consolidating banks’ balances. If the recovery fails to materialize, or funding conditions worsen notably (not their base case though),  they expect the CNB to react to the extent allowed by the FX stability, fiscal backstop (EDP anchor) and external risk mitigation.

Croatia Economy