World Bank: Croatia EU Convergence Report proposes recommendations
Zagreb, September 14, 2009 – Over the last 15 years, Croatia achieved impressive economic
and social progress. Prior to the onset of the global crisis, the Croatian economy grew at a
healthy 4-5% annually. The country maintained macroeconomic stability and favorable social
development indicators. Croatia’s per capita income reached about 63% of the European
Union average, and membership in the EU is well within reach.
Looking beyond the current global recession and beyond EU membership, what should
Croatia be doing to speed up economic growth in a fiscally, socially and environmentally
sustainable fashion and reach income levels similar to those of the more developed EU
countries? What could be the future engines of high economic growth? What policies and
actions could be considered by the Croatian authorities and other stakeholders to further
improve the standard of living of Croatian citizens in the decades to come?
The World Bank’s Croatia EU Convergence Report: Reaching and Sustaining Higher Rates
of Economic Growth, is trying to respond to those questions, looking at different segments of
economic policy. It proposes recommendations on how to reach convergence with the EU
countries in a fast yet sustainable and socially sensitive fashion.
The report discusses how Croatia could sustain and accelerate growth over the coming
decades, by focusing on four economic policy strategies: (i) increasing the contribution of
labor, by raising the rate of the population’s participation in the workforce and reducing
unemployment; (ii) raising total factor productivity; (iii) deepening trade integration; and (iv)
fostering innovation.
The report and its findings, which are summarized in the attached brief, are discussed today at
a joint National Competitiveness Council and World Bank Conference held at Novinarski
dom.
The report was prepared in close consultations with government authorities and other
stakeholders. Three workshops with key stakeholders were held to discuss preliminary
findings while the report is based on a survey of about 600 companies.
Summary of Key Recommendations of the Croatia EU Convergence Report
Increasing Employment: Labor Market Reforms and Education
1. Effective labor market reforms would likely have a positive impact on economic
growth. Croatia’s employment rate (at about 58 percent of the working age population
in 2008) is lower than the average for the EU-27 countries. This is the result of low
labor participation rate and high unemployment. Thus, the contribution of labor to
economic growth in recent years, although increasing somewhat over time, has been
modest: less than one percentage point out of the almost five percent growth in the
2002-2007 period. If Croatia could raise employment rates closer to the EU’s Lisbon
targets (including an overall employment rate of 70 percent), the country could
increase its income level by an estimated 15.7 percent in 2025 (and 22.9 percent in
2040). This estimated boost in incomes corresponds to more than twice the expected
effect for the average EU-27 country. What are the main obstacles to increasing the
contribution of labor to economic growth in Croatia?
2. In order to increase the contribution of labor to economic growth, Croatia would
need to raise labor participation and reduce unemployment. Recent reforms in the
overall system of social security benefits in Croatia do not encourage participation in
the labor market, particularly female participation. Raising labor participation requires
the reduction of disincentives for the supply of labor which are embedded in the
current social protection system. In addition, increased flexibility of firms to adjust
their labor force to the business cycle, the better alignment of the cost of labor with
labor productivity, and the alleviation of the current skills mismatch would likely
result in lower unemployment rates. The following economic policy options might be
considered:
o Aligning the incentives for labor supply by: (i) reviewing the incentives for
early retirement implicit in current legislation and developing incentives to
bring older workers back to work; (ii) reassessing the effects of unlimited
duration unemployment benefits for older workers; (iii) integrating the
currently inactive younger population, like war veterans and a large share of
social welfare beneficiaries, back to the labor market; (iv) adopting a more
forward-looking migration policy; and (v) assessing the effectiveness of
current demographic policies.
o Increasing the demand for labor by: (i) enhancing labor market flexibility; and
(ii) containing artificial increases in labor costs.
o Reducing skill mismatches by enhancing the responsiveness of vocational
education and training (VET) and the tertiary education system to labor
market needs with the provision of (i) better labor market information on
occupational trends; (ii) transparent information on employment status of
graduates from VET and higher education programs; (iii) functional integration
of Croatian universities; and (iv) more flexible adjustments of enrollment
quotas in education and training programs.
o Enhancing Croatia’s life-long learning (LLL) system by: (i) developing a LLL
Strategy encompassing all forms of learning; (ii) increasing participation in
adult education; (iii) involving employers (as well as students and graduates) in
the governance of VET and higher education institutions.
3. The proposed strategy of increasing employment would probably generate the
highest returns in terms of raising and sustaining economic growth of any of the
policy areas discussed in the report. However, international experience suggests that
labor reforms are also likely to be associated with the most complex political economy
environment.
Raising Productivity: “Creative Destruction” and the Investment Climate
4. In Croatia today, many low and average productivity firms coexist with a smaller
group of highly productive plants. This provides an opportunity for raising
aggregate productivity. Higher (total factor) productivity could be achieved by (a)
bringing the average efficiency of less productive firms closer to the higher
productivity ones by improving critical aspects of the investment climate; and/or by
(b) the reallocation of resources now poorly used in inefficient firms towards more
efficient firms, through an enhanced process of so-called “creative destruction” (faster
firm entry and exit). The report estimates that if Croatia could achieve a total factor
productivity growth rate of 2.4 percent per year until 2020, roughly a one percentage
point increase from the recent rate, the country’s per capita income could be about 9
percent higher than it would have been otherwise. A 2.4-percent TFP growth rate,
albeit ambitious, is similar to what was achieved by Ireland in the 1990s.
5. Policies to raise aggregate productivity in Croatia could address both (a) factors
hindering market dynamism, and (b) investment climate factors reducing
technical efficiency. The contribution of allocative efficiency (the relative share of the
more productive firms in total output) to aggregate productivity in Croatia is lower
than in other countries that have emerged from import substitution regimes (e.g. Brazil
and India), suggesting that major gains could still be obtained by improving allocative
efficiency. The report identifies 15 out of more than 120 possible variables related to
the investment climate in Croatia that significantly affect average firm productivity.
These factors include: (i) the time required for a firm to obtain an import license; (ii)
the skills of labor force; (iii) the extent to which workers in the production process use
computers, and (iv) web-use. Together, factors like these offer a set of priorities for
policies aiming at improving the technical efficiency of Croatian enterprises. The
following economic policies might be considered:
o In order to foster enterprise restructuring and market dynamism, Croatia might
(i) re-ignite the privatization process and improve corporate governance in
remaining state owned enterprises; (ii) reduce state aid for declining sectors
and streamline the bankruptcy process to improve exit conditions; (iii) improve
product market regulation (with the full implementation of regulatory impact
assessment requirements and elimination of unnecessary barriers to firm
entry); (iv) liberalize entry into the service sector (particularly retail and
infrastructure); and (v) complete market reforms in the agriculture sector.
o In order to improve the investment climate and foster average productivity
gains, Croatia might (i) reduce the time required to obtain a license for
international trade (especially imports); (ii) enable access to information and
communication technology (ICT) capital by small and medium size enterprises
(SMEs) and (iii) increase labor skills (in the short-term by a focus on
improving VET and LLL, but also reviewing the obstacles for the provision of
training by firms). Streamlining custom clearance is also needed. Croatia could
use OECD’s experience with policies to facilitate technology adoption
(particularly ICT) by SMEs to further enable computer-use by the enterprise
sector.
o Further analysis is required of the reasons why the provision of transportation
services by the private sector appears (based on enterprise surveys) to be a
significant constraint, apparently especially for enterprises with lower market
shares and those focused in the domestic and local markets – thus forcing the
relatively less efficient use of their “own transportation services”.
o Preliminary evidence on an apparent positive association between access to
non-banking finance and total factor productivity at firm level suggests further
examination of the role of non-banking financial institutions in the selection of
best investment opportunities and thus in fostering growth in Croatia.
6. While major gains could be obtained, strengthening the process of “creative
destruction” inevitably creates winners and losers, with a risk for the political
feasibility of reforms. Sector and regional differences may accentuate the risk of
economic policy reversals, and thought will need to be given to appropriate
mechanisms to deal with these risks.
Deepening Trade Integration: Foreign Direct Investment and the Supply of
Exportable goods
7. Experiences of growth acceleration suggest that deepening of Croatia’s trade
integration could be further explored as an additional source of faster growth
and convergence. When measured in real (price-adjusted) terms, Croatia’s trade
integration (the share of the value of total exports and imports in total GDP) is around
50 percent, much lower than in many comparable countries in the region. Several
studies confirm that the country is exporting below its estimated potential. Croatia’s
export growth rate, while increasing significantly in recent years (to 17 percent on
average in 2002-08), has been consistently below that of the economies of Central and
Eastern Europe.
8. In order to deepen its trade integration, Croatia would need to expand the supply
of exportable goods and attract more Foreign Direct Investment (FDI). Obstacles to
higher exports are mainly of a microeconomic nature: incomplete corporate
restructuring has limited productivity gains in traditional export sectors, as well as
diversification towards new products and new markets. In particular, Croatia’s current
degree of specialization in tourism exposes it to a highly volatile sector. In addition,
econometric analysis indicates that various cross-cutting issues affect the propensity of
local firms to export, including such factors as: firm productivity, days to clear
customs to export, and the availability of a firm’s own transportation. The analysis
also confirmed that foreign-owned firms are more likely to export. Attracting export-
oriented FDI may therefore be a feasible strategy for further diversification of the
country’s exports. The suggested economic policy measures are as follows:
o In order to attract export-oriented FDI, Croatia might (i) facilitate access to
land, (ii) address the problem of frequent electricity outages, (iii) improve trade
regulations, and (iv) further streamline regulations affecting foreign
investment. Surveyed firms also consider the inadequacy of labor supply, tax
rates and tax administration to be among the top 10 obstacles for the expansion
of foreign-owned companies in Croatia. In this context, a broader effort to
strengthen FDI promotion activities is recommended.
o In order to develop the supply of exportable goods, Croatia might (i) improve
trade-related services, (ii) raise standards of quality certification, and (iii)
reduce logistics costs. An overall strategy to increase the level of information
about foreign markets would be beneficial. Croatia’s Metrology, Standards,
Testing and Quality (MSTQ) infrastructure needs to be more fully integrated to
global norms. As Croatia has an extensive network of transport infrastructure,
and public investments in roads have already risen significantly in recent years,
the achievement of further efficiency gains in the transport sector will likely
require the continuation of railways restructuring and the mobilization of
additional private financing for infrastructure projects.
9. Leveraging the benefits of the global economy is important, even though a decline
in trade volumes in the context of the current global crisis may limit the benefits
from such a strategy in the near-term. Standard trade policies, complemented by
measures to foster enterprise restructuring and market dynamism, would encourage
exporting firms to raise their productivity (i.e. shipbuilding), and enable new, more
productive firms to enter the market. Synergies between trade and innovation policies
could also be explored, as innovation policies may help export diversification, further
trade integration may help technology absorption, and FDI promotion policies could
also target R&D-intensive FDI.
Fostering Innovation: Knowledge Commercialization and Use
10. Croatia could further expand and sustain growth by transforming existing
knowledge into productivity gains and innovation. The country has a long tradition
of scientific activity, but knowledge commercialization is still in early stages, as
indicated for example by the fact that only 6 percent of Croatian firms applied for a
patent in the 2005-07 period. Interestingly, this result contrasts with a fairly high level
of technology adoption, as suggested by the large share (44 percent) of workers using
computers in the production process. In addition to the low level of patenting, total
R&D expenditures are also relatively modest, at approximately 1 percent of GDP.
This report estimates that, by judiciously increasing the R&D to GDP ratio to 3
percent (the target set by the EU’s Lisbon Agenda), Croatia could increase its income
by around 6 percent in 2025 (and 8.2 percent by 2040).
11. In order to foster the innovation and technological progress, Croatia’s innovation
policy should encourage the commercialization of knowledge. Enabling the private
sector to transform knowledge into productivity gains and innovation requires (i)
focusing public support to R&D on mobilizing private R&D, (ii) further adjusting the
incentive regime for research commercialization, with a view to reducing the current
bias against applied research and development, and (iii) encouraging science-based
start-ups. Of particular relevance is the supply of researchers and professionals with
higher education. At 5.6 percent, the share of science and technology graduates in the
population in Croatia is lower than in most countries in the region and the EU average
of 13 percent. The main recommendations of the report in the area of innovation
policy are the following:
o Increasing private R&D by: (i) benchmarking existing tax-incentives against
those in leading innovative economies and assessing their impact on the
promotion of private R&D, (ii) assessing to what extent public R&D activity
(given the limited supply of human resources) may be “crowding-out” private
R&D, and (iii) considering the option of attracting R&D-intensive FDI in
consultation with the FDI promotion agency.
o Improving conditions for collaboration between university and industry by: (i)
reviewing criteria for progress in the academic career, (ii) simplifying legal
requirements for cooperation, (iii) reassessing the overall incentives embedded
in the legal regime, (iv) reviewing the benefits provided by BICRO’s SPREAD
program, and considering the adoption of a matching-grant scheme, and (v)
promoting the development of technology/innovation “brokers” that would
help the development of joint-projects to be supported by current programs.
o Enabling the start-up of science based companies by: (i) supporting the
development of technology transfer offices, (ii) reviewing the regulatory
bottlenecks for the development of a venture capital industry in the country,
(iii) encouraging market-oriented activities of public research institutes and
technology parks, and (iv) promoting the restructuring of public R&D
institutes by adopting a system of declining earmarked funding, and
introducing researcher-level incentives for diversification of revenues.
o Improving the overall governance structure of Croatia’s National Innovation
System (NIS) by establishing a strategy for gradual implementation of a
monitoring and evaluation system, consolidating and institutionalizing some of
the programs (such as those for the support of the Diaspora), and clarifying the
roles of BICRO and the Croatian Institute of Technology.
12. In seeking to foster innovation and technological progress in Croatia, two caveats
should be kept in mind. First, because the main challenge is the commercialization of
knowledge and not knowledge generation, standard science and technology (S&T)
policy measures should be complemented by selected investment climate reforms that
encourage the private sector to demand knowledge. Second, as innovation will be
incremental in nature and not necessarily consist of radical breakthroughs, it would be
advisable that S&T policies do not discriminate against, and if possible support, the
less-high technology sectors, including textile, footwear and agriculture, which also
need to improve their technological level.
