Croatia Business Forecast Report Q4 2009

The Downturn Deepens We believe that 2009 is likely to be the worst year for economic growth in Croatia in over 10 years.

However, while we only expect the recession to last through 2009, we caution that the recovery is likely to be more 'L' than 'V'-shaped. Indeed, with external credit conditions unlikely to return to the state seen prior to the international crisis anytime in the foreseeable future, and with the European consumer undergoing a lengthy period of deleveraging and saving, demand for Croatian exports will remain subdued for some time yet. In addition, Croatia's accession to the EU continues to be delayed as a result of the ongoing land dispute with Slovenia. As such, with international credit conditions set to take some time to thaw, and with real convergence potentially slowing as long as Croatia remains outside the EU, we believe that growth will settle on a lower trend path over the medium term. This underscores our forecast for real GDP to expand by an average 2.9% over the course of 2010-2013, below the more buoyant 4.3% average seen during 2005-2008.

Upon announcing his resignation, Prime Minister Ivo Sanader nominated his deputy and long-serving supporter, Jadranka Kosor, as prime minister-designate. A key challenge now facing Kosor will be to push badly-needed budget revisions through parliament as early as possible. Indeed, with recent GDP data showing a more severe contraction than originally anticipated (-6.7% growth y-o-y in Q109), and with financial support from the IMF still lacking, the government is coming under increasing pressure to tighten up the public finances. Though the spending cuts will almost certainly prove unpopular (according to some reports, they could amount to HRK3.0bn), and will likely dent the government's support further, the deterioration in tax revenues will necessitate a curtailment of public expenditure to prevent the fiscal situation deteriorating sharply.

The severity of the collapse in international trade has been keenly felt in Croatia and this is reflected in the balance of payments, with goods exports falling by 13.7% y-o-y during Q109 on the back of the eurozone's unfolding recession. In addition, services exports tumbled 10.0% y-o-y over the same period, with Croatia's tourism exports in particular likely to have suffered as consumers in the EU tighten their purse strings. Though there has been much talk recently of early signs of recovery in the eurozone, and a slowdown in the pace of economic contraction, we caution that 2009 will remain a tough year for the European consumer, with 2010 still unlikely to see a revival of pre-2008 levels of demand. As such, we still hold to our view that external demand for Croatian exports will remain subdued over the remainder of 2009 and 2010, with a meaningful recovery unlikely to take place until 2011 at the earliest.

Despite the bumpy ride in Croatian disinflation, with headline consumer price growth ticking up twice so far in 2009 amid an overall downtrend which has been playing out since the mid-2008 inflationary peak, we still see prices heading lower by end-year. The latest reading shows consumer price inflation easing to 2.7% y-o-y in May from 3.9% the previous month and marking the slowest rate of growth since August 2007. While inflationary pressures have already come off considerably during the first five months of the year, we still hold to our 1.1% end-year inflation target, with a projection of average inflation of 2.0% throughout 2009.