Croatia Economic Insights: Optimism, but there's always another side

At the end of February, the first estimate of GDP for 2024 will be known. Following a real GDP growth rate of 3.8% over the first three quarters, the already available Q4 2024 indicators suggest similar trends to continue. These trends are characterized by a strong contribution from domestic demand, particularly personal consumption and investments, reflecting a robust growth in real retail trade turnover (up 6.6% yoy in Q4 2024) and construction activities (up 15.8% yoy Oct-Nov). On the other hand, strong domestic demand, coupled with solid tourist demand, is driving import growth, which, along with a slight decline in exports of goods and services, will ultimately result in a net negative contribution from foreign demand. Nevertheless, with a real GDP growth rate of (at least) 3.6%, Croatia remains, for the fourth consecutive year, among the fastest-growing economies in Europe.

Consequently, the level of real GDP would be almost 19% higher compared to the end of 2019, and the GDP per capita, in terms of purchasing power parity, could approach 78% of the EU average (+11 pps higher compared to the end of 2019).

Amid a robust labour market characterized by low unemployment, slight but positive employment growth, and a mismatch between labour supply and demand, pressure on wage growth is likely to continue. This is due to the spillover effects of previous and announced (for this year) public sector wage increases and the administrative rise in the minimum wage. Although we expect a more moderate growth rate for both nominal and real wages, it will still be relatively high and thus pose a risk to the disinflation process, i.e., the gradual reduction of consumer inflation (see Croatia Watch: Inflation at 3% in 2024). In such conditions, the key issue of sustainable growth – productivity – gradually comes into focus, as it lags behind the productivity of the EU countries even in the most dynamic sectors, such as information and telecommunications.

The recovery of demand from key foreign trade partners (the euro area) is highly uncertain, and at least for 2025, the outlook is not optimistic. Additionally, the current structure of Croatian industrial production and the export of goods and services does not suggest a significant positive contribution from net foreign demand. Specifically, industrial production, which concluded 2024 with a decline, is characterized by a relatively high share of resource-based and a low share of high-tech and medium-tech intensive products. In terms of service exports, tourism and transport services are predominant. Croatia experiences a trade deficit in almost all sectors of its foreign relations. For example, according to the Standard International Trade Classification (SITC), a surplus is recorded only in the “Raw Materials (excluding fuels)”. Therefore, although the export of goods has been growing (in nominal terms), it remains insufficient and uncompetitive.

As for tourism in 2025, we expect arrivals and overnight stays to continue to grow at modest single-digit rates, mainly due to the expected positive developments outside the main seasons during which Croatia has been operating at its peak capacity. However, risks are skewed to the downside due to lower price competitiveness on one hand, and the fact that the purchasing power of guests from our most important markets, primarily Germany and Austria, has decreased.

In the past two years, the reduction in overnight stays from the German market was compensated by guests from Central European countries (Slovenia, Hungary, Poland). However, with decreasing price competitiveness and changing guest preferences, tourism-related activities will face ongoing and continuous challenges, necessitating rapid adjustments. For decades, Croatia has been perceived as a (cheap) sun and sea destination with traditionally loyal (family) guests, but this is slowly changing. Overall, persistent changes on the demand side are an additional factor that should drive changes on the supply side.

Short-term negative risks to our base scenario forecast primarily stem from the global geopolitical environment, uncertainty and instability. As a small and open economy, Croatia is sensitive to spillover effects from the global environment which could hit tourism first.

The economic outlook until 2027 remains favourable, with average growth rates between 2.5% and 3%, aligning with the potential growth rate. From 2027 to 2030, despite the conclusion of the RRF, it is important to note that the European funds from the EU's Multiannual Financial Framework for the period 2021-2027 can still be used for additional three years (n+3), ensuring continued support for both private and public investments. Of course, the rates we have seen in the past two years are unlikely.

The important issue of sustainable and stable growth and development largely depends on the implementation of the anticipated reforms and investments under the National Recovery and Resilience Plan, as they are expected to bring long-term benefits in terms of a more favourable business environment, strengthening institutions, and the rule of law. Although Croatia is still a frontrunner in withdrawing these funds (and the 6th tranche is on its way), the real effects and implementation are still to be seen.

We consider reforms of major public systems – ranging from education and healthcare to the judiciary and public enterprises – to be crucial in creating the conditions for higher quality and more sustainable growth and development, as well as a society based on knowledge and innovation.

The biggest challenges for economic policymakers in the medium to long term remain strengthening the rule of law, addressing demographic trends, improving relatively low productivity, and reducing large regional disparities among the Croatian counties.

Fiscal statistics are available for the period from January to September 2024. As expected, employee expenses in the first nine months were almost 45% higher compared to the same period in 2023. When pensions are included, the contribution of these two categories to the overall expenditure growth in the observed period reached 65%. Subsidy expenses were 43.6% higher. At the same time, relatively strong economic growth based on consumption continues to benefit state budget inflows, as indirect taxation, particularly on consumption, constitutes a significant source of state revenue. Total revenues in the first nine months of last year were 7.1% higher on an annual basis, with VAT revenues up by 14%, contributing as much as 70% to the overall growth. According to comparable statistics (based on ESA 2010 methodology) published by Eurostat, the general government deficit in the cumulative period of the last four quarters, at the end of September 2024, amounted to 2.3% of GDP, making Croatia, along with Slovenia, the best performer compared to countries in the region. During the observed period, public debt fell to 59.7% of GDP. We are still waiting for indicators to complete the fiscal picture for 2024, but with the continued relatively strong economic growth, we do not rule out the possibility of a stronger decline in the public debt-to-GDP ratio compared to our projections. Such trends, through continued revenue growth, will also impact the general government deficit, which, despite worsening compared to 2023, could be better than our expectations and slightly below 2%.

The tax changes as part of the new round of tax reforms that came into effect at the beginning of 2025, including adjustments and increases in pensions, the increase in the minimum wage and personal allowance, and the increase in salaries for civil servants (3% from February 1 and additional 3% from September 1), along with the expected wage growth in the private sector, will favour further consumption growth. Consequently, this will reflect positively on the revenue side of the budget, at least in the first part of the year.

During 2025, with the growth of nominal GDP supporting revenue growth, additional inflows into the state treasury are expected from changes in the taxation of property and rental income. We expect the 2025 general government budget deficit to remain around the levels of the previous year, with a further gradual reduction in the public debt-to-GDP ratio.

In an environment where the ECB is easing monetary policy and lowering key interest rates, local monetary authorities are left with only macroprudential measures to rein in consumer lending and curb spending through the credit channel. However, it is becoming increasingly clear that the real key lies in fiscal policy. Despite the need for restraint, fiscal policy remains expansionary, acting more like fuel to an already overheated engine rather than the brake it should be on strong demand. This contradiction raises serious questions about the sustainability of current economic strategies.