Croatia’s New Government Faces ‘Unpopular’ Economic Choices

Croatians elected a four-party opposition bloc that needs to trim the budget deficit and reduce corruption to bring the nation out of a recession and into the European Union in 2013.

The Social Democrats and three other parties that make up the Alliance for Change, or Kukuriku, won 80 of parliament’s 151 seats, the electoral commission reported with all votes counted. The ruling Croatian Democratic Union, which had governed for 17 of the last 21 years, took 47, with smaller parties winning the rest. Results are expected to be finalized on Dec. 7, after challenges to the count are heard. Social Democrat leader Zoran Milanovic, a 45-year-old lawyer and former diplomat, will be the next premier.

The Alliance campaigned on pledges to bring fiscal order back to the government and spark a tourism-dependent economy out of a recession. The nation had its credit rating reduced a year ago to BBB-, one step above junk at Standard & Poor’s, which cited a “deteriorated fiscal position and continuously weak” external financing.

“On paper, the new government’s economic program seems to be in the right direction, but we have to wait for their budget proposal,” said Michele Napolitano, Associate Director at Fitch Ratings, which has Croatia assessed at BBB-, its lowest investment grade. It’s “too soon” to say how the new government will impact Croatia’s credit rating, he added.

Croatian five-year credit-default swaps, which are used to insure bondholders against the risk of non-payment, were at a three-week low of 523 basis points at 1 p.m. in Zagreb, down from 527 basis points on Dec. 2 and a year-high 589 basis points on Nov. 25. Still, Croatian debt is the third-most expensive to insure against default in eastern Europe after Hungary and Ukraine.

Slow Recovery

Croatia is taking longer than its Balkan neighbors to climb out of a recession that began more than two years ago. GDP rose 0.6 percent in the third quarter from the same period a year ago and the October jobless rate, at 17.4 percent, is more than double compared with EU members Germany and the Czech Republic.

In neighboring Slovenia, the governing party was also defeated as Ljubljana Mayor Zoran Jankovic’s Positive Slovenia scored a surprise victory in a general election yesterday with voters looking for a change in leadership to tackle rising debts and a faltering economy.

The Croatian central bank forecasts GDP to rise 0.5 percent this year and Napolitano said Fitch sees the expansion slowing in 2012, adding urgency to creating fiscal policies that will keep the situation from deteriorating. Once Milanovic gets a mandate from the president to form a government, he has 30 days to form a Cabinet and submit it to parliament for approval.

Unpopular Decisions

“Fitch’s real GDP growth forecast for the next year is 0.3 percent, much lower than the 2.5 percent on which the current budget is based,” he said by phone from London. “Therefore, with weaker revenue growth, the government would need to cut expenditures, particularly in pensions, ministerial budgets and public sector wages. These are not popular decisions to take.”

The Alliance for Change said during the campaign it would cut waste from the pension system and lure investments in energy, transport and tourism to create jobs and revive the economy. The measures would cut the budget gap, now at 6.2 percent of GDP, in half over the next four years as the country integrates into the EU.

Strong Mandate

Milanovic’s strong mandate “should allow the government to work efficiently,” Hrvoje Stojic, chief analyst at Hypo Alpe-Adria-Bank d.d., a local unit of Austria’s Hypo Alpe-Adria-Bank International AG said by phone in Zagreb. “But this is also a Pyrrhic victory, as they inherit an economy in a prolonged structural depression.”

Stojic forecasts the economy will contract 2 percent next year, while Zdeslav Santic, chief analyst at Soc-Gen Splitska Banka d.d., said it will contract 2.1 percent. Central bank Governor Zeljko Rohatinski said in October growth should be “mild” and similar to this year.

Financing Help

Milanovic should act “quickly” to agree with the International Monetary Fund on a financing accord to bolster the budget and set strict spending policies as it “would further inspire markets” and may “begin to mark Croatia out over other regional credits which have been perhaps foot-dragging both in terms of closing agreements with the IMF, but more broadly in terms of reform momentum,” Tim Ash, head of emerging-markets research at RBS in London, said in an e-mailed note.

The Alliance, which adopted the rooster’s cry of Kukuriku as its name during the campaign, includes the Croatian People’s Party, the Istrian Democratic Party and the Croatian Party of Retirees. It wants to sell non-controlling stakes in state companies, abolish the 20 percent tax rate on reinvested profit and add a tax on dividend payouts.

The government must “very quickly” reduce the budget gap by about 1 billion euros ($1.3 billion), execute structural reforms in the public sector, and reform the tax system so that a drop in payroll taxes is offset by a VAT hike, which imitates the impact of a currency depreciation,’’ Sotjic said.

“We hope that the rating agencies will wait to see the first steps of the new government,” Branko Grcic, the new government’s top economic strategist, said by phone. “Obviously, we are not in the best situation, as the price of borrowing is now 7 percent and higher. We will urgently start with the reforms and with the fiscal consolidation, so we can use the funds to generate growth.”

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