Recent Economic Developments and the Competitiveness of the Croatian Manufacturing Industry

The Vienna Institute for International Economic Studies (WIIW) Recent Economic Developments and the Competitiveness of the Croatian Manufacturing Industry Final Report Vienna, October 2002

This report was produced in the framework of an agreement between the Office of the President of the Republic of Croatia and The Vienna Institute for International Economic Studies (WIIW). Financial support for this work has been granted by the Austrian Ministry of Forewing Affairs.

Contents Executive summary i Introduction 1 1 Recent economic developments in Croatia 2 2 Croatian manufacturing industry: trends in growth and structure 7 Development trends in the Croatian manufacturing industry 7 The Croatian manufacturing industry in the region 8 The structure of the Croatian manufacturing sector in detail 12 Growth profile across branches 14 Patterns of international competitiveness across branches 17 3 The services sector in Croatia 21 Trade in services 27 4 Foreign trade 32 Foreign trade the aggregate picture 32 Foreign trade some comparisons 36 Foreign trade structure 42 Croatian trade performance with the EU(15) 49 Trade specialization, branch balances and RCA in trade with the EU 50 Factor content and trade specialization 53 Market share analysis: best and least performing industries in EU markets 55 5 Foreign direct investment in Croatia 58 FDI in the region 62 Data sources 66 Abbreviations 66 References 67 Appendix 1 69 Appendix 2 71

List of Tables and Figures Table 1 Croatia: Selected economic indicators 3 Table 2 Croatia: Indicators of industrial development, 1990-2001 8 Table 3 Manufacturing value added, in per cent of GDP 9 Table 4 Gross industrial production, real change in per cent against preceding year 10 Table 5 Labour productivity in industry, change in per cent against preceding year 11 Table 6 Manufacturing employment, in per cent of total 11 Table 7 Croatia: Overview of production and employment, 2001 12 Table 8 Structural deviation of Croatian manufacturing production 13 Table 9 Croatia: Growth patterns across manufacturing branches, production growth (at constant prices 1996) 17 Table 10 Croatia: Monthly gross wages and labour productivity in the Croatian manufacturing industry, 2001 18 Table 11 Croatia: Productivity gains and losses in manufacturing, 1998-2001, average annual change in per cent and relative gains in percentage points 20 Table 12 Croatia: Unit labour costs in manufacturing compared to Austria, 2001 (Austria 2000 = 100) 21 Table 13 Employment structure in selected CEECs, 2001, based on LSF 22 Table 14 Croatia: Gross value added by activity: current prices / real growth rates / per cent of total 23 Table 15 Gross value added by activity in selected CEECs, 2000, in per cent of total 25 Table 16 Services balance (net) in selected CEECs, in USD million / in per cent of GDP 28 Table 17 Trade balance (net) in selected CEECs, in USD million / in per cent of GDP 28 Table 18 Travel services balance (net) in selected CEECs, in USD million / in per cent of GDP 29 Table 19 Transport services balance (net) in selected CEECs, in USD million / in per cent of GDP 29 Table 20 Other services balance (net) in selected CEECs, in USD million / in per cent of GDP 30 Table 21 Export of services in selected CEECs, in USD million / in per cent of GDP 31 Table 22 Export of goods in selected CEECs, in USD million / in per cent of GDP 32 Table 23 Croatia: Foreign trade development, 1990-2001 33 Table 24 Croatia: Exports by partner, in per cent of total 34 Table 25 Croatia: Imports by partner, in per cent of total 36 Table 26 Foreign trade of CEECs and SEECs, in ECU/EUR million (based on customs statistics) 37 Table 27 Trade balance as a share of GDP, in per cent of GDP 39 Table 28 SEEC exports by country, 2001, in per cent of total exports 40 Table 29 SEEC imports by country, 2001, in per cent of total imports 41 Table 30 Croatian and Slovenian foreign trade with former Yugoslav republics 42 Table 31 Croatia: Exports by commodity group, current prices, per cent of total 43 Table 32 Croatia: Imports by commodity group, current prices, per cent of total 44 Table 33 Exports by commodity group, 2001, current prices, per cent of total 45 Table 34 Imports by commodity group, 2001,current prices, per cent of total 45

Table 35 Croatia: Exports by NACE section, current prices, per cent of total 47 Table 36 Croatia: Imports by NACE section, current prices, per cent of total 48 Table 37 EU(15) manufacturing trade with Croatia, 1995-2000, In EUR million, without intra-eu trade 50 Table 38 Croatia: Best and least performing industries in exports to the EU(15), 1995-2000, ranked by competitive gain, EUR million 56 Table 39 CEEC(10): Best and least performing industries in exports to the EU(15), 1995-2000, ranked by competitive gain, EUR million 57 Table 40 Croatia: Foreign direct investment inflow and stock, 1993-2002 56 Table 41 Croatia: Foreign direct investment by investing country, 1993-2001, inflow, USD million 59 Table 42 Croatia: Foreign direct investment by sector, 1993-2001, inflow, USD million 60 Table 43 Foreign direct investment in the manufacturing industry, 2001, USD million 61 Table 44 FDI stock, end of year, USD million 62 Table 45 FDI stock per capita, USD 63 Table 46 FDI stock as a percentage of GDP 63 Table 47 FDI stock by major investing country, as of December 2001, shares in per cent 64 Table 48 FDI stock by major economic activity, as of December 2001, shares in per cent 65 Table A1 WIFO Taxonomy 69 Figure 1 Manufacturing production structure in comparison to the EU, 2000 14 Figure 2 Croatia: Winner and loser branches of manufacturing, 1991-1995 and 1996-2001, average annual changes relative to total manufacturing, in percentage points 15 Figure 3 Croatia: Foreign trade by region, in per cent of total 35 Figure 4 Comparison of total exports (1993-2001), in EUR 38 Figure 5 Croatia: Share in manufacturing exports to the EU(15), in per cent / Share in manufacturing imports from the EU(15), in per cent / Sectoral trade balances with the EU(15), EUR million 51 Figure 6 Croatia: Revealed comparative advantage in trade with the EU(15) / Relative revealed comparative advantage in trade with the EU(15) 52 Figure 7 Shares in Croatian and CEECs exports to the EU by factor inputs: Technology-driven industries / Marketing-driven industries / Capital-intensive industries / Labour-intensive industries / Mainstream industries 54

Executive summary This third report concentrates on structural developments in the Croatian economy and on competitiveness. Some of the distinct characteristics are presented in comparison with developments in other Central and Eastern European (CEE) as well as South Eastern European (SEE) economies. The relatively poor performance of manufacturing and deteriorating competitiveness emerge as specific features from this comparison. During the last decade a process of deindustrialization was taking place in the Croatian economy, due to disruptions caused by the war and the loss of former important Yugoslav and Soviet Union markets. The share of industry (i.e. mining & quarrying, manufacturing and electricity, gas & water supply) in GDP declined, the share of manufacturing in GDP fell from approximately 26% in 1990 to 19% in 2001, its share in employment fell from 37% to 24%.After years of negative growth in the first half of the 1990s, growth rates for industry and manufacturing have turned positive since 1995 and 1996 respectively. Growth rates in industry were higher compared to the less developed South Eastern European countries, but significantly lower than in the Central and Eastern European countries in recent years. Gross industrial production reached only 60% of the 1989 level in 2001 in Croatia, while the CEEC-5 s industrial production reached 115%. Croatian manufacturing production stood at 54% of the 1989 level in 2001. Manufacturing output declined in all branches until 1995, followed by a long period of stagnation in almost all branches of Croatian manufacturing. A clear recovery occurred in paper & printing only, which slightly surpassed the 1990 level in 2001 for the first time. Other more successful branches were transport equipment and other non-metallic mineral products, with 80%. On the other hand, leather & leather products experienced a continuous fall in production and stood at 24% of the 1990 production level in 2001. In 2001, for the first time, both overall industrial production and manufacturing increased by a higher rate (6.4%) than GDP (4.1%). It is also the first year that industrial production in Croatia (6%) grew faster than in the Central and Eastern European countries (3%). However, data for the first months of 2002 show again a slower industrial growth rate compared to last year. Moreover, employment levels in manufacturing are still falling, although the share of manufacturing employment in total employment is on average already smaller than in the other transition countries. Thus, at this stage, it is too early to confirm a true turning point for Croatian industrial development. i

The structure of Croatian manufacturing concentrates on food & beverages, coke & refined petroleum products and chemicals, which together account for around 50% of manufacturing output today. Major employers are food & beverages, textiles & textile products and basic metals & fabricated metal products. Major exporters are transport equipment, textiles & textile products, and chemicals together with coke & refined petroleum products. The three largest exporting branches to the EU(15) are textiles & textile products, chemicals and also electrical & optical equipment. Compared to the countries of the European Union and the Central and Eastern European countries, the Croatian manufacturing production structure is more similar to the less advanced countries of the 'EU-South' and also to Bulgaria and Romania, than to the more advanced transition countries. Also in terms of exports to the EU(15), Croatia shows strong similarities to Bulgaria and Romania, all three featuring a high share of labour-intensive and marketing-driven industries with a near absence of technology-driven industries in their export structures to the EU(15). Factors of competitiveness including wages, productivity and unit labour costs are considerably less favourable than in the other CEECs. Manufacturing unit labour costs (defined as wage rates divided by productivity) are relatively high compared to the other CEECs and only slightly below those of Slovenia and range between 67% and 96% of the Austrian level. In certain industries such as transport equipment, electrical & optical equipment and leather & leather products unit labour costs are already higher than in Western Europe, creating clear cost problems for these industries. Croatia is one of the most advanced services economies among the transition countries, with services contributing close to 60% to gross value added and employing 58% of the total workforce. Measured as a proportion of the GDP, non-market services have a relatively high level in Croatia comparable to that in the EU, implying that the country like other transition economies is lagging behind in the market services segment. The main shortcomings consist in the lower efficiency and quality of services (e.g. tourism) in Croatia and the dominance of traditional services sectors over higher value added services sectors. The importance of the tertiary sector becomes the more evident in foreign trade, where about half of total exports is conducted in services, first of all tourism. In contrast to the persistently high deficits in commodity trade, trade in services shows the highest surplus compared to other transition countries, making up 14.5% of the GDP in 2001 (in Hungary, coming next, the respective value was 4.2%). The surplus in tourism alone accounted for 13.5% of the GDP. Apart from its role as an important source of foreign exchange earnings, the extraordinary position of the services sector is underlined by its high proportion in the total FDI stock, first of all in the transport and telecom segment. ii

Croatia's foreign trade is characterized by a huge and growing deficit: A slightly positive trade balance in 1992 shifted to an extremely negative position of around USD 4.4 billion in 2001. While exports have been oscillating around an average of USD 4.4 billion since 1992, imports doubled to USD 9 billion in 2001. Hence in 2001, Croatia was able to cover only roughly half of its imports by exports. Compared to the CEEC-5, Croatian exports are among the lowest (in absolute terms and as a share of GDP) and the trade deficit is the largest in the region. Relating the trade deficit to the GDP, Croatia is the leader in this statistic since 1995, with high double-digit shares. In 2001, it amounted to nearly 22% of GDP. Recent trade developments are further discouraging, as Croatia experienced in the last year and at the beginning of 2002 much higher growth of imports than of exports. Real exchange rate appreciation over the last three years is among the most important factors explaining the worsening trade performance. More than half of Croatian exports go to the EU, with Italy being Croatia s most important trading partner in 2001, which is quite a common pattern in the SEECs. By contrast, for the CEEC-5 Germany is the most important export partner. Since the mid-1990s the former Yugoslav republics are gaining again importance for Croatian exports. This does not hold true for imports, where especially the share of Russian imports increased strongly (highly dependent on the price of oil). The EU s share, while still accounting for more than half of the imports, diminished somewhat. The most important group of commodities amongst Croatian exports is machinery and transport equipment (29%), which experienced a strong rise in recent years mainly due to higher, but volatile, production in shipbuilding. However, this is also the main group of imports with an even higher share of one third in 2001, due in parts to high car imports. As a result, machinery and transport equipment had the largest trade deficit of more than USD 1.8 billion in 2001. It has to be noted, however, that amongst the countries under comparison only the Czech Republic and Hungary had a positive trade balance in this group. Out of ten commodity groups in Croatia, only two groups, namely beverages and tobacco and crude materials (inedible) except fuels, had a slightly positive trade balance in 2001, although low in absolute terms. On the EU(15) market, Croatian manufacturing exports decreased their position between 1995 and 2000 as market shares (in extra-eu imports) fell significantly from 0.42% to 0.26%. Croatia registered a growing trade deficit with the EU during this period, with the deterioration being observable in most branches of manufacturing, pointing to a widespread weakening of Croatian international competitiveness. Industries which show a comparative advantage today are labour-intensive branches including wood & wood products, textiles & textile products and leather & leather products, while more sophisticated branches such as transport equipment, machinery & equipment and electrical equipment show a comparative disadvantage (as measured by relative iii

revealed comparative advantage values) although there was an improvement for the latter two branches between 1995 and 2000. FDI inflows to Croatia have increased substantially since 1998. In 2001, the inflows even amounted to USD 1.5 billion. Croatia's FDI stock of USD 6.7 billion equals nearly one third of all investments in the SEEC-7 and is comparable to the FDI stock invested in the Slovak Republic. Measured as a share of GDP, the Croatian FDI stock in 2001 of more than 33% puts Croatia on place number three of the CEEC-5 and the SEEC-7 group of countries, behind the Czech Republic and Hungary. 36% of the FDI stock was invested in manufacturing, with the most prominent targets being chemicals and other non-metallic mineral products. However, this is the lowest share when compared to the shares of the CEEC-5, Bulgaria and Romania. 30% of the Croatian FDI stock was invested in the transport, storage and communications sector, with main investments resulting from the privatization of Croatian Telecom; 19% was invested in financial intermediation. Some 3% of the FDI stock was invested in the hotels and restaurants sector, which is less than one might be expecting in a country with high potential for tourism. However, privatization in this segment is not at an advanced stage (which also explains the low FDI presence), but will be very important for the qualitative improvement of this sector. iv

Recent Economic Developments and the Competitiveness of the Croatian Manufacturing Industry Introduction In this Quarterly, we are looking into the competitiveness of the Croatian economy. As in the previous two, we compare the performance of the Croatian economy with that of other transition countries. We address this issue because it has been recognized by us, in the previous two issues, as well as by many other observers as one of the crucial long-term problems that the firms in Croatia are facing. Our findings are given in a summary and in a detailed form, so there is no need to go into them in this introduction. Therefore, we will just comment on the importance of some of the policy issues that we discussed in the previous two instalments in light of these findings. It will also give us an opportunity to pick up certain issues that have been raised in some of the debates that our previous reports have elicited. In the second issue, entitled 'Enduring Problems', we commented on the monetary and fiscal policy that Croatia had followed over the years. The problems we had in mind are those connected with the exchange rate and fiscal policies. We did not advocate any alternative policy, though some have imputed to us the suggestion that Croatia should follow a more lax monetary and more strict fiscal policy. That is only one possibility, however. As can be read in the recent IMF reports, 1 there is a possibility of adopting a more active monetary policy and more restrictive fiscal policy. Indeed, the IMF now suggests that the Croatian National Bank may consider adopting the policy of inflation targeting. We discussed this possibility in our 'Enduring Problems' study. As for fiscal policy, there seems to exist quite a consensus that the deficit will have to be watched carefully. As we suggested in the previous issue, this is a particularly sensitive area. Croatia s primary surplus, public expenditures net of interest payments of the public debt minus public revenues, is quite negative. In the recent comments on our report the researchers from the Croatian National Bank 2 acknowledge that this level of deficit is unsustainable. The IMF argues also that the public debt to GDP ratio cannot be stabilized at the current level of fiscal imbalance. There seem to have existed a difference of opinion among different observers in the assessment of the level of fiscal discipline exhibited by the Croatian government in 2001. That disagreement is not crucial, especially in light of the projection for the current and near-term fiscal deficits. 1 2 We summarize the main finding of one of them in our Appendix below. See E. Kraft and T. Strucka (2002), 'Fiscal Consolidation, External Competitiveness and Monetary Policy: A Reply to WIIW', Croatian National Bank, Surveys, May. 1

In Croatia, as in many other countries, there is the usual debate about the relative importance of macroeconomic versus structural adjustment. The arguments used have also not been all that new. Some have argued that macroeconomic adjustment is necessary, by which mostly exchange rate depreciation is meant. Others argue that structural adjustment is the cure. Still, it is generally not doubted nowadays that macroeconomic policies tend to run into problems unless structural changes of an appropriate form are forthcoming. Having looked into the macroeconomics, we, in this report, look into one albeit crucial issue that underpins the need for structural reforms. 1 Recent economic developments in Croatia Key economic indicators show a diverse picture during 2002: disinflation continued, unemployment remained at high levels, the foreign trade deficit worsened and industrial output growth lost momentum compared to last year. After an impressive performance in 2001, industrial production growth has been fluctuating from month to month and slowed to 3.1% in the first eight months of 2002; manufacturing output grew by 2.4%. Within manufacturing, branches that performed well during the past years have exhibited the strongest growth and vice versa: the fastest rate of expansion has been in publishing and printing, pulp and paper, electrical machinery and machinery and equipment. The worst performance has been recorded by low-value-added sectors such as the production of tobacco, wearing apparel, leather products, but also the production of radio and TV sets. Some branches showed a strong correlation between output growth and decline, respectively, and their export performance (measured in current kuna terms): for instance, exports of publishing and printing went up by more than 20%, and those of machinery and equipment expanded by 36%, whereas exports of coke and refined petroleum, wearing apparel and leather products fell substantially. Continued layoffs translated into a further increase in labour productivity. Retail trade showed again very dynamic growth with real turnover up 13% during the first seven months of 2002. Expanding domestic demand was the major force behind GDP growth in the first and second quarters of 2002, up by an unexpected 4.1% during the first half of the year. Thus, Croatia was one of the fastest growing economies among the transition countries over that period. Investments, having grown by almost 10% in 2001 after two years of decline were up again during the first half of 2002, by 9%. That was mainly due to an increase in infrastructure investments in the framework of a housing programme and for motorway building. The construction industry had recovered only in 2001 after two years of substantial decline. Household consumption was further accelerating and grew by 6%, while government consumption continued its path of decline starting in the second quarter of 2000. The increase in private consumption was stimulated primarily by rising loans to the household sector, up about 40% in nominal terms between July 2001 and July 2002, while at the same time loans to the enterprise sector rose by 20%. 2

Table 1 Croatia: Selected economic indicators 1997 1998 1999 2000 2001 1) 2001 2002 2002 2003 January-June forecast Population, th pers., mid-year 2) 4573 4501 4554 4437 4437.... Gross domestic product, HRK mn, nom. 123811 137604 141579 152519 162909 78510 83868 179300 192100 annual change in % (real) 6.8 2.5-0.9 2.9 3.8 4.1 4.1 3.5 4 GDP/capita (USD at exchange rate) 4398 4805 4371 4153 4403.... GDP/capita (USD at PPP - WIIW) 7870 8290 8230 9080 9520.... Gross industrial production 3) annual change in % (real) 6.8 3.7-1.4 1.7 6.0 5.9 2.2 3 3 Gross agricultural production annual change in % (real) 4.0 10.2-3.5-10.0 8.4.... Goods transport, public, mn t-kms 4) 203428 170107 146302 143839 142338.... annual change in % -4.6-16.4-14.0. -1.0.... Gross fixed capital form., HRK mn, nom. 29935.6 32065.6 33025.0 33281.0 37022.0 18518.0 21273.. annual change in % (real) 26.4 2.5-3.9-3.8 9.7 9.7 9.1 6 6 Construction industry, hours worked 3) annual change in % (real) 16.7 0.7-7.7-9.1 3.6 0.8 11.7.. Dwellings completed, units 12516 12557 12175 12187 18088.... annual change in % -0.9 0.3-3.0 0.1 48.4.... Employment total, th pers., average 5) 1310.9 1384.8 1364.5 1341.0 1348.3 1319.5 1330.4.. annual change in % 5) -1.4 0.4-1.5-1.7 0.5-1.5 0.8.. Employees in industry, th pers., average 319.7 308.9 299.5 291.9 287.2 283.7 278.7.. annual change in % -6.4-3.4-3.0-2.5-1.6-3.4-1.7.. Unemployed reg., th, end of period 287.1 302.7 341.7 378.5 395.1 364.9 385.0.. Unemployment rate in %, end of period 17.6 18.1 20.4 22.3 23.1 21.5 22.2 22.5 22 Average gross monthly wages, HRK 3668 4131 4551 4869 5061 5027 5272.. annual change in % (real, net) 12.3 6.0 10.1 3.4 1.6 1.4 1.7.. Retail trade turnover, HRK mn 34736.1........ annual change in % (real) 14.9 0.1-3.5 10.0 10.0 11.7 11.6.. Retail prices, % p.a. 6) 3.6 5.7 4.2 6.2 4.9 6.4 2.5 2.5 3 Producer prices in industry, % p.a. 2.3-1.2 2.6 9.7 3.6 6.1-1.9.. Central government budget, HRK mn 7) Revenues 33846 43809 46356 44636 53444 20153 32670.. Expenditures 35006 42552 48879 50744 57202 24533 35532.. Deficit (-) / surplus (+) -1160 1257-2523 -6108-3759 -4380-2868.. Deficit (-) / surplus (+), % GDP -0.9 0.9-1.8-3.9-2.2-5.6-3.4.. Money supply, HRK mn, end of period M1, Money 13731 13531 13859 17941 23704 19065 28254.. Broad money 50742 57340 56659 73061 106071 79690 106593.. Discount rate % p.a., end of period 5.9 5.9 7.9 5.9 5.9 5.9 5.9.. Current account, USD mn -2512.2-1452.8-1390.4-432.8-642.0-1415.2-1458.9-800 -900 Current account in % of GDP -12.5-6.7-6.9-2.3-3.2-15.1-14.4-3.5-3.6 Gross reserves of NB excl. gold, USD mn 2539.1 2815.7 3025.0 3524.8 4704.2 3798.5 5601.8.. Gross external debt, USD mn 7451.6 9586.2 9872.3 11002.2 11134.0 11286.4 13194.0.. Exports total, fob, EUR mn 8) 3665.8 4046.2 4027.3 4818.0 5210.4 2488.2 2521.6 5400 5700 annual growth rate in % 1.8 10.4-0.5 18.9 8.1 10.1 1.3 4 5 Imports total, cif, EUR mn 8) 8059.7 7476.9 7324.1 8588.5 10084.6 5019.4 5319.3 11000 12100 annual growth rate in % 29.6-7.2-2.0 16.8 17.4 30.7 6.0 9 10 Average exchange rate HRK/USD 6.16 6.36 7.11 8.28 8.34 8.39 8.28.. Average exchange rate HRK/EUR (ECU) 6.96 7.14 7.58 7.63 7.47 7.55 7.42 7.5 7.6 Purchasing power parity HRK/USD, WIIW 3.44 3.69 3.80 3.96 4.00.... Purchasing power parity HRK/EUR, WIIW 3.77 4.04 4.14 4.32 4.36.... Notes: 1) Preliminary. - 2) From 2000 according to census March 2001. - 3) Enterprises with more than 19 employees. - 4) From 2000 new methodology. - 5) From 1998 including persons employed at the Ministry of Defence and Ministry of Internal Affairs. - 6) From Aug 2001 adjustment lowering telecom prices. - 7) From June 2001 including extrabudgetary funds; from Jan 2002 including social security funds. - 8) From 2000 new method of statistical processing. Converted from the national currency to EUR at the official exchange rate. Source: WIIW Database incorporating national statistics; WIIW forecasts. 3

Inflation continued its downward trend, reaching the lowest level since Croatia gained independence: during the first eight months half of 2002 retail prices increased by 2.4% on average, in August by 1.2% year-on-year. The Croatian National Bank (CNB) frequently intervened on the foreign exchange market in order to prevent an appreciation of the kuna, which resulted in net purchases of over EUR 600 million until June. So far the government has been unable to combat the high unemployment. Despite a declining number of unemployed starting from April, the jobless rate remained high, at close to 22%, in August the highest rate among the more advanced transition countries. Labour force survey data reveal a significantly lower but still marked rate of unemployment: 16% in the second half of 2001 (data for 2002 are not available yet). But even by that measure Croatia s unemployment rate is much more similar to the high-unemployment transition countries, i.e. Bulgaria and Slovakia (close to 19.5% each) than to the lowunemployment countries such as Hungary (5.7%) and Slovenia (6.4%). Looking at the structure of unemployment, as in most other transition countries the share of long-term unemployed in Croatia has been increasing over the last decade and accounted for 56% of total unemployed in 2001; the proportion of those out of work for more than two years was close to 40%. The magnitude of long-term unemployed was similar as in the Czech Republic and in Slovakia, but lower than in Slovenia and Bulgaria (Hungary and Poland are the main exceptions where the share was only slightly over 40%). The incidence of unemployment is highest for young people up to the age of 24 years, with an unemployment rate of 41%. This represents the highest rate compared to the other transition countries (CEEC-7) 3 and is similar to that in Poland, while Hungary s youth unemployment rate is about 10%. In general the incidence of youth unemployment in transition countries is closely associated with the total level of unemployment (see also UN/ECE, 2002). Similar as in other CEECs and in the European Union, unemployment is geographically highly concentrated. The registered unemployment rate ranges from 13% in Zagreb to 40% in Vukovar Srijem and 39% in the county of Sibenik-Knin. In contrast to other CEECs, where the spatial pattern of unemployment mainly reflects the inherited industrial structures, in Croatia it is strongly correlated with the war. Following an employment increase in 2001 (0.5% according to recently revised data) for the first time after a decade of decline, the number of employed continued to increase slightly during the first months of 2002. However, it is too early yet to speak of a reversal of trends. Job increases have first of all a seasonal character with most of the employment rises recorded in tourism, construction and trade. The dramatic job losses over the past decade are also reflected in low activity and employment rates; for instance, in Croatia only 3 CEEC-7: the Central and East European countries Bulgaria, the Czech Republic, Hungary, Poland, Romania, Slovakia and Slovenia. 4

slightly more than half of the total working-age population are actually employed, while in the Czech Republic and Slovenia this proportion accounts for almost two thirds. Having weakened considerably in 2001, real wage growth has gained momentum from month to month in 2002 with real net and gross wages up by 2.1% and 3.1% respectively during the first half of the year. Trends in foreign trade have remained unchanged. Though slowing down as compared to 2001, import growth remained high during the first half of 2002: imports rose by about 6% in euro terms, while at the same time exports grew by 1.3%. Thus, the trade deficit increased by EUR 270 million as against the same period a year earlier. Trade with the European Union developed unevenly. Total exports to these markets rose by 3.1%, which more or less corresponds to the export performance of the CEEC-5 4 to that area. However, exports to Germany, Croatia s second most important trading partner, fell by almost 20%. Imports from the EU rose by 5%. The trade balance with the other Yugoslav successor states deteriorated, but remained positive. The most important trading partner in this area has been Bosnia and Herzegovina, while trade with Slovenia has been losing momentum from year to year. In a comparative perspective Croatia's export performance remains different from that of other CEECs. Data for the first half of 2002 indicate a higher export growth for most of the CEECs, with the exception of Bulgaria and Macedonia which report export declines by 2% and 12% respectively. The growth of the trade deficit was higher than elsewhere in the CEECs and SEECs higher by 10% compared to the same period a year earlier. In the past it was repeatedly argued that one of the main reasons for Croatia s poor export performance was the lack of trade associations (Sonje and Vujcic, 1999), thus discriminating exporters as they were facing higher tariffs than other CEEC competitors or deterring foreign investors due to the lack of an association agreement with the EU. However, although Croatia has undertaken many steps towards integration since 2000, became a member of the WTO and has concluded a series of bilateral trade agreements and a Stabilization and Association Agreement (SAA) with the European Union, its trade performance (especially that of exports) has remained weak. Following the deterioration of the trade balance, the current account closed with a USD 1.4 billion deficit in the first half of 2002. Only enhanced earnings from tourism prevented an even stronger growth of the current account deficit. Assuming a continuation of the current trends in foreign trade, the trade balance will end up with a higher deficit in 2002 than a year earlier. This would lead to a deterioration of the current account deficit despite the expected increase in earnings from tourism. Foreign direct investment (FDI) inflows amounted to USD 580 million, nearly 70% of which were directed towards the banking sector. Last year Croatia was able to attract FDI worth USD 1.5 billion, the most favourable result after 1999. This year substantial foreign investment is expected to come 4 CEEC-5: the Czech Republic, Hungary, Poland, Slovakia and Slovenia. 5

through the partial privatization of the INA oil company and the privatization of Croatia Osiguranje. After a fall in January foreign debt grew substantially in the subsequent months and reached USD 13.3 billion at the end of July 2002 (up USD 2.1 billion or nearly 19% against December last year), which is equivalent to two thirds of the GDP. In addition there are USD 1.6 billion of publicly guaranteed debt. Apart from the issuing of bonds to cover structural reform costs, one of the major reasons for this extraordinary jump of Croatia s external debt is the weakening of the US dollar against the euro two thirds of the country s debt is denominated in euros. The debt service burden (repayment of principal and interest) is estimated by the CNB at USD 1.6 billion in 2002, about USD 2.2 billion in both 2003 and 2004 and close to USD 2 billion in the two consecutive years. 5 Foreign currency reserves of the CNB have been steadily on the increase, reaching a record level of USD 5.8 billion by August 2002. Several methodological changes make it difficult to assess the current fiscal developments and to compare them with those of earlier years. The health and pension funds were incorporated into the state budget, the funds for the Croatian Highways and Road Construction were excluded and two new funds, the Regional Development Fund and the Development and Employment Fund, were newly established. In the first half of the year the central budget deficit amounted to HRK 3 billion. In late September the Minister of Finance announced a revision of the 2002 budget in order to cover extraordinary expenditures amounting to about HRK 1.3 billion for wages in the defence, internal security and education sectors and for additional social expenditures. Thus, the restrictive (public sector) wage policy introduced in accordance with the IMF did not meet the original expectations, as reforms in the defence sector were delayed and some adjustments were made in the collective agreements in education. The deficit was financed by the issue of government bonds on the international market, by short-term securities on the domestic market, by a World Bank loan and by privatization earnings. At the end of June 2002 public debt totalled HRK 69 billion (of which close to HRK 42 billion foreign debt), by 90% higher than by the end of 1998. At the same time the ratio of public debt (including publicly guaranteed debt) relative to the GDP rose by approximately 16 percentage points. The consolidated general government anticipates a 6.6% deficit to GDP ratio in 2002 (IMF, preliminary conclusion of the mission), a relation that is unsustainable in the long run. So far the actual magnitude of the deficits has been concealed by privatization earnings, but once these dry up the government will face a serious debt service burden. The IMF has called for a further reduction of expenditures, such as for wages, subsidies and transfers. The wage bill still high by international standards should be reduced by further layoffs, 5 Data refer to the CNB Bulletin nos. 70 and 73. 6

primarily in the defence and health sectors; employment cuts in other sectors such as public administration and education are likely. These measures will of course counteract the government goal of increasing employment; instead, they will increase the pool of unemployed. In addition a wave of bankruptcies is expected till the end of 2002, mostly of smaller companies, employing about 70,000 persons. Thus the government s employment programme, envisaging the creation of around 14,000 new jobs this year, seems to be just a drop in the ocean. The emerging private sector is still too weak to absorb redundant labour from the state sector. 2 Croatian manufacturing industry: trends in growth and structure Development trends in the Croatian manufacturing industry 6 Similar to other transition countries, a process of deindustrialization could be observed in the Croatian economy starting at the beginning of the 1990s (see Table 2). The share of manufacturing in the gross domestic product was falling continuously from more than 26% in 1990 to some 18% in 1999. This massive loss abated somewhat in the last two years, when the level of manufacturing stabilized at 19% of GDP. Nevertheless, the contribution of manufacturing to GDP has fallen from over a quarter to less than one fifth over the past decade. Labour productivity in industry has been increasing since 1992 at an average annual rate of approximately 6%. However, this is due to large employment cuts rather than to higher production. In 1990, employees in manufacturing had accounted for more than 37% of total employees. Today, less than 24% of total employees are employed in manufacturing. Latest data on employees in industry in the first quarter of 2002 show a somewhat lower drop (-1.6%) compared to the first quarter of 2001 (-3.5%). This process becomes even more obvious when comparing the output levels. While GDP in 2001 reached 84% of the 1989 level and gross industrial production some 60%, manufacturing production reached less than 54% of the 1989 level. By the mid-1990s the level of manufacturing production had even more than halved. Since 1996, manufacturing production is on the rise again. Nevertheless, in 2001 it was for the first time in more than a decade that manufacturing production (+ 6.4%) rose faster than gross industrial production (+6%) and gross domestic product (+4.1%). Latest data on gross industrial production in the first quarter of 2002 indicate a somewhat lower growth of 1.9%, compared to 5.6% in the first quarter of 2001. 6 In the following, the term 'industry' comprises 'mining and quarrying', 'manufacturing' and 'electricity, gas and water supply'. 7

Table 2 Croatia: Indicators of industrial development, 1990-2001* 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 1) Value Added in % of GDP Industry total..... 22.8 21.6 21.9 21.1 21.6 22.3 22.5 Manufacturing 2) 26.1 26.5 25.9 25.9 22.8 19.5 18.2 18.4 17.9 18.1 19.0 19.2 Index (1989=100) Gross Domestic Product 92.9 73.3 64.7 59.5 63.0 67.3 71.3 76.2 78.1 77.7 80.6 83.9 Gross Industrial Production 88.7 63.4 54.1 50.9 49.6 49.7 51.3 54.7 56.8 56.0 56.9 60.3 Manufacturing Production 87.6 61.3 51.6 47.9 46.8 46.6 47.2 49.0 50.6 49.2 50.6 53.8 Real change in % against preceding year Gross Domestic Product -7.1-21.1-11.7-8.0 5.9 6.8 5.9 6.8 2.5-0.4 3.7 4.1 Gross Industrial Production -11.3-28.5-14.6-5.9-2.7 0.3 3.1 6.8 3.7-1.4 1.7 6.0 Manufacturing Production -12.4-30.1-15.8-7.1-2.4-0.3 1.3 3.8 3.2-2.9 2.8 6.4 Labour productivity in industry change in % against preceding year -7.2-13.2 0.3 0.3 3.0 6.6 11.3 11.9 8.7 3.9 4.3 9.3 Employees in % of total employees Manufacturing 3) 37.2 35.4 34.9 34.7 34.7 34.0 30.3 28.6 25.6 24.9 24.3 23.8 Notes: * Industry data cover enterprises with more than 20 employees. - 1) Preliminary. - 2) Data for 1990-1994 according to the former UCEA classification (Unified Classification of Economic Activities) 'Manufacturing and mining', for 1999-2001 WIIW estimates. - 3) Data for 1990-1995 according to the former UCEA classification 'Manufacturing and mining'. Source: WIIW Database incorporating national statistics. The Croatian manufacturing industry in the region Put in a comparative perspective, Croatian manufacturing value added as a percentage of GDP performs quite poorly (see Table 3). In 1997, the only year for which data are available for all CEECs and some of the SEECs (i.e. Bulgaria, Romania, Macedonia and Yugoslavia), Croatia featured the second lowest share of manufacturing value added in GDP (18.4%) after Bulgaria. Although that share has somewhat increased over the past years, Croatia has still one of the lowest shares compared to the other transition countries. The evolution of the low importance of manufacturing in the overall economy of Croatia is quite similar to the one in Poland, which fell behind Croatia in 2000 while other CEECs managed to keep their shares of manufacturing in GDP over 20%. Hungary has even increased its share since the mid-1990s, from less than 20% to close to 22% of GDP. The Czech Republic and Slovenia are the top performers with manufacturing value added accounting for about one quarter of total GDP. 8

Table 3 Manufacturing value added in per cent of GDP 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 1) Czech Republic 24.6 27.0 27.4 23.2 24.1 24.3 25.9 26.2 25.0 24.3 25.0 25.3 Hungary. 19.8 19.8 19.4 19.4 19.8 19.7 21.1 21.2 20.5 21.7. Poland.. 26.9 25.2 24.3 20.6 19.5 19.5 18.8 18.4 18.1. Slovak Republic... 19.7 18.0 23.2 23.4 21.8 21.5 21.3 21.3 21.3 Slovenia 29.9 31.0 28.4 25.9 26.2 24.6 24.1 24.3 24.1 23.6 24.0 23.7 Bulgaria...... 20.4 16.6 17.1 15.1 15.7 15.5 Romania 36.7 31.7 30.0 26.6 28.7 26.5 28.8 25.7 23.0... Croatia 2) 26.1 26.5 25.9 25.9 22.8 19.5 18.2 18.4 17.9 18.1 19.0 19.2 Macedonia 3) 31.5 24.4 29.4 25.1 28.8 19.6 19.5 20.6.... Yugoslavia....... 21.0 21.6 21.9.. Notes: 1) Preliminary. - 2) Data for 1990-1994 according to former UCEA classification 'Manufacturing and mining', for 1999-2001 WIIW estimates. - 3) Data for total Industry. Source: WIIW Database incorporating national statistics. Comparing the growth of Croatian industrial production with other countries of Central and Eastern Europe as well as South Eastern Europe, one could summarize that the Croatian position is the best out of the less advanced group of countries, but the worst compared to the more economically advanced group (see Table 4). This holds certainly true if one compares the 2001 level of industrial production with the year 1989. Croatia s 60% are far above the level of Bulgaria (51%), Romania (54%), Macedonia (46%) and Yugoslavia (39%). However, a comparison with the 115% of the 1989 level for the CEEC-5 changes the picture dramatically. The average growth rates of the past seven years show a similar picture. Croatia s 2.9% are far behind the 5.8% of the CEEC-5. Only Slovenia's gross industrial production grew somewhat less (2.3%) than Croatia's in the period from 1995 to 2001. Nevertheless, the Slovenian level compared with 1989 is much higher (83%) than the Croatian one. Looking again at other SEECs, the Croatian record looks quite well, as in some of those countries (Bulgaria and Macedonia) industrial production even declined on average over this period. It is worth noting that 2001 was the first year for Croatian industrial production to grow faster (6%) than the CEEC-5 (3%). The first quarter of 2002 shows an even stronger catching-up of 1.9% against the 0.5% of the CEEC-5. 9

Table 4 Gross industrial production real change in per cent against preceding year Index 1989=100 1995 1996 1997 1998 1999 2000 2001 1) 2001 2002 2002 2003 2001 1st quarter forecast Czech Republic 8.7 2.0 4.5 1.6-3.1 5.4 6.8 10.0 4.2 5.5 7 87.2 Hungary 4.6 3.4 11.1 12.5 10.4 18.6 4.1 10.6 0.2 4 9 142.0 Poland 2) 9.7 8.3 11.5 3.5 3.6 6.7 0.0 4.5-1.5 0 2 129.6 Slovak Republic 8.3 2.5 2.7 5.0-2.7 8.6 6.9 7.8 1.1 4 4 95.5 Slovenia 2.0 1.0 1.0 3.7-0.5 6.2 2.9 4.7 1.7 3 4 82.6 CEEC-5 3) 8.3 5.1 8.5 4.6 2.4 8.4 3.0 7.1 0.5 2.4 4.6 115.3 Bulgaria 4.5 5.1-5.4-7.9-9.3 10.3-2.4 2.5-3.1 3 4 50.5 Romania 9.4 6.3-7.2-13.8-2.4 7.1 8.2 10.8 3.0 4 4 53.7 Croatia 4) 0.3 3.1 6.8 3.7-1.4 1.7 6.0 5.6 1.9 4 4 60.3 Macedonia 5) -10.7 3.2 1.6 4.5-2.6 3.5-3.1-8.6-14.4-10 -3 45.9 Yugoslavia 5) 3.8 7.6 9.5 3.6-23.1 11.2 0.0-0.3-4.1 3 3 38.6 Notes: 1) Preliminary. - 2) Sales; quarterly data refer to enterprises with more than 9 employees. - 3) WIIW estimate. - 4) Enterprises with more than 20 employees. - 5) Excluding small enterprises. Source: WIIW Database incorporating national statistics, forecast: WIIW. Comparing data on labour productivity in industry across CEECs and SEECs gives a more complex and mixed picture (see Table 5). Looking at the level of labour productivity in industry in terms of 1989, Croatia is above the SEECs and even some of the CEEC-5 (the Czech and Slovak Republics) with 143% of the 1989 level. This reflects the extreme cuts in employment that were carried out in Croatian industry. The growth rates of Croatian labour productivity in 2001 (9.3%) and in the first quarter of 2002 (7.4%) were among the highest compared with the other CEECs and SEECs. It is important to note that the comparison of Croatian employment data is somewhat limited due to the fact that unlike in other transition countries where total employment in manufacturing is put in relation to total employment in the economy (including persons in paid employment and self-employed persons), Croatian statistics allow only for data on employees in manufacturing in relation to total employees (comprising only persons in paid employment). With more than 37% of total employees in manufacturing in the year 1990, Croatia had a higher employment share in manufacturing than the Czech Republic (33%) (see Table 6). However, in 2000 the share of employment in manufacturing in the Czech Republic was higher by some 5 percentage points compared to the Croatian share of over 24% of employees in manufacturing as a percentage of total employees. While all CEECs and SEECs experienced cuts in manufacturing employment over the past decade, most 10

Table 5 Labour productivity in industry change in per cent against preceding year Index 1989=100 1995 1996 1997 1998 1999 2000 2001 1) 2001 2002 2001 1st quarter Czech Republic 2) 8.7 8.6 9.2 3.7 1.7 9.5 4.9 8.8 3.4 137.6 Hungary 3) 10.2 9.4 13.7 11.9 10.5 18.2 5.9 10.8 3.0 236.2 Poland 4) 6.3 9.1 11.2 4.7 11.8 14.0 5.8 9.6 5.5 199.5 Slovak Republic 4.0 2.5 4.8 9.1 0.2 12.1 5.9 6.6 3.1 130.6 Slovenia 6.3 9.2 4.4 5.4 3.1 8.4 3.5 4.4 4.8 156.8 Bulgaria 5) 7.4 7.0-2.8-3.8 0.8 20.4 1.9 7.3-7.8 125.3 Romania 13.7 7.5-1.8-7.4 11.3 13.8 11.5 15.9 2.3 116.5 Croatia 6) 6.6 11.3 11.9 8.7 3.9 4.3 9.3 9.3 7.4 142.7 Macedonia 7) 1.2 29.8 8.3 14.8 6.4 6.0-7.2.. 101.5 Yugoslavia 7) 8.3 9.6 12.3 6.3-19.1 16.4 3.4 3.0. 60.2 Notes: 1) Preliminary. - 2) In 1995 and 1996 enterprises with 100 and more, from 1997 with 20 and more employees. - 3) From 1995 enterprises with more than 10, from 1999 more than 5 employees. - 4) Quarterly data refer to enterprises with more than 9 employees. - 5) Up to 1996 public sector only. - 6) Enterprises with more than 20 employees. - 7) Excluding small enterprises. Source: WIIW Database incorporating national statistics. Table 6 Manufacturing employment in per cent of total 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 1) Czech Republic 32.9 33.7 32.1 31.2 29.2 28.8 28.6 29.2 29.3 29.2 29.2. Hungary.. 25.8 24.5 23.7 23.1 23.3 23.7 24.7 24.4 24.2 24.8 Poland.. 21.0 20.8 20.5 21.1 20.6 20.2 19.7 18.9 18.2. Slovak Republic.... 26.8 26.8 27.0 25.7 26.1 25.7 25.7. Slovenia 40.3 39.3 38.6 36.6 35.2 34.4 32.9 31.4 30.8 29.9 29.4 29.3 Bulgaria...... 23.8 23.8 22.9 21.1 20.7 20.1 Romania 34.3 31.3 27.4 25.9 24.5 24.2 24.5 23.0 22.3 20.6 19.6. Croatia 2)3) 37.2 35.4 34.9 34.7 34.7 34.0 30.3 28.6 25.6 24.9 24.3 23.8 Macedonia 2)4) 40.6 40.3 39.6 39.8 39.9 38.3 37.6 36.8 36.6 37.9 36.7. Yugoslavia 2)5) 38.0 37.7 37.4 35.7 35.5 34.9 34.2..... Notes: 1) Preliminary. - 2) Employees in per cent of total employees. - 3) Data for 1990-1995 according to former UCEA classification 'Manufacturing and mining'. - 4) Data for total industry. - 5) Excluding the private sector. From 1998 including small enterprises. Source: WIIW Database incorporating national statistics. 11

CEEC-5 recorded just smaller losses or even gains of manufacturing employment as a percentage of the total in the period 1996-2000. In the same period, Croatia experienced a loss, in terms of employees in per cent of total employees, of 6 percentage points; thus, in employment terms, deindustrialization is still proceeding at a rapid rate over the more recent period. The structure of the Croatian manufacturing sector in detail In 2001, the Croatian manufacturing industry featured a production volume (at current prices) of EUR 10.5 billion and employed a workforce of 252,000 persons. Production strongly concentrates on food & beverages (DA), coke & refined petroleum products (DF) and chemicals (DG), which together account for about 50% of manufacturing output. Employees are slightly less concentrated the three largest branches together account for 43% of manufacturing employment. The major employers are food & beverages (DA), textiles & textile products (DB) and basic metals & fabricated metal products (DJ). Other relatively important branches, both in terms of production and employees, are transport equipment (DM), paper & printing (DE), electrical & optical equipment (DL) and other non-metallic mineral products (DI, see Table 7). Table 7 Croatia: Overview of production and employment, 2001 Production 1) Employees 2) EUR mn in % of ths. persons in % of manuf. prod. manuf. NACE D Manufacturing total 10447.4 100.0 251.9 100.0 DA Food products; beverages and tobacco 2342.0 22.4 45.2 18.0 DB Textiles and textile products 487.6 4.7 38.5 15.3 DC Leather and leather products 102.9 1.0 10.1 4.0 DD Wood and wood products 303.7 2.9 12.7 5.0 DE Pulp, paper & paper products; publishing & printing 777.9 7.4 17.0 6.8 DF Coke, refined petroleum products & nuclear fuel 1696.8 16.2 4.5 1.8 DG Chemicals, chemical products and man-made fibres 1176.4 11.3 14.6 5.8 DH Rubber and plastic products 300.9 2.9 7.2 2.9 DI Other non-metallic mineral products 550.8 5.3 13.8 5.5 DJ Basic metals and fabricated metal products 700.2 6.7 24.7 9.8 DK Machinery and equipment n.e.c. 290.6 2.8 11.7 4.6 DL Electrical and optical equipment 732.7 7.0 17.8 7.1 DM Transport equipment 637.5 6.1 21.0 8.3 DN Manufacturing n.e.c. 347.7 3.3 13.1 5.2 Notes: 1) At current prices for the year 2000. - 2) Persons in paid employment. Source: WIIW Industrial Database incorporating national statistics. 12