Croatia’s monetary policy is based on a “managed” exchange rate float, which has helped insulate the economy from overly inflationary pressures in the past. The kuna (HRK, the local currency) gradually appreciated versus the EUR from 2015 to 2018 and stabilized around 7.42 per EUR in 2019. As the Covid-19 pandemic led to investor panic in March-April 2020, the HRK depreciated somewhat but less than most other Emerging Market currencies. For 2020 as a whole, we expect the HRK to fall by an average -2% versus the EUR before it stabilizes again in 2021. Meanwhile, consumer price inflation has been moderate since 2017, averaging +1.5% in 2018 and +0.8% in 2019, though the latter was helped by a significant reduction in VAT rates. In 2020, consumer prices moved into mild deflationary territory from April onwards as the impact of Covid-19 hit domestic demand and labor markets. We expect average inflation of +0.2% in 2020 and +1.1% in 2021.
Currency and price stability have helped to lower Croatian interest rates markedly. The long-term interest rate for Eurozone convergence purposes (10-year government bond yields denominated in local currency) fell to 2.04% at end-2018 and further to 0.59% at end-2019 before edging up to 0.85% in August 2020.
Public finances weakened markedly in the course of the extended 2009-2014 recession, with public debt more than doubling from 39% of GDP in 2008 to 84% in 2014 as fiscal deficits exceeded -5% of GDP year after year. But the deficit narrowed rapidly to -0.9% in 2016 and shifted to annual surpluses in 2017-2019, thanks to revenues benefiting from the growth rebound and fiscal restraint. For 2020, however, we expect a large deficit of -7.6% of GDP or so as a result of lower fiscal revenues and increased spending as well as lower nominal GDP in the wake of the Covid-19 crisis. Public debt declined to 73% of GDP in 2019 but is forecast to rise again to around 80% in 2020-2021.
As a result of its prudent economic policies in recent years, Croatia was admitted to the Exchange Rate Mechanism II (ERM-II), the “waiting room” for eventual adoption of the EUR, in July 2020. In conjunction with ERM-II membership, the country also joined the European banking union in October 2020. Is Croatia ready to join the Eurozone? Three out of the five “hard” criteria for the adoption of the EUR are currently, in principle, fulfilled: exchange rate stability vs. the EUR, low inflation and low long-term interest rates. The fourth criteria, a fiscal deficit below -3% of GDP, was fulfilled from 2016-2019 and only got off track due to the Covid-19 crisis. The fifth criterion, public debt below 60% of GDP, has not been achieved yet and it may still take some time to do so, especially after Covid-19. However, in its latest Convergence Report from June 2020, the ECB and European Commission acknowledged that “leaving aside the policy measures to address the Covid-19 pandemic, a prudent fiscal policy ... should put the debt ratio on a long-lasting downward path”. And then there is a “soft” criterion for entering the Eurozone, the so-called institutional readiness. The June 2020 Convergence Report notes that there are still some deficiencies with regard to the business environment and the institutional framework, including that Croatian law does not yet fully comply with the requirements for central bank independence. We conclude that Croatia could adopt the EUR in 2023 at the earliest, though it may take two or three years longer.