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Cablegate: Questions Loom On Croatia's Debt As Pm Announces A

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1. (SBU) Summary. Prime Minister Sanader has announced his
intention to balance the federal budget in 2009 and has
called for a salary freeze and cutbacks in Christmas
activities in both the government and state-owned industries
to achieve this aim. The PM feels he has little room for
maneuver in fiscal policy as the possibility of securing
credit abroad has evaporated, and the government faces major
debt-servicing bills in the very near future. Nevertheless,
economic experts here agree that the government has enough
financing options domestically, for the moment, to avoid a
debt crisis or intervention by the IMF. But they also
question whether political horse-trading over salary
increases can either balance the budget or help Croatia avoid
whatever risks it faces from the world financial crisis.
They say Croatia's challenge is not its federal deficit, or
even its high household debt, rather the relative inability
of the economy to produce sufficiently competitive goods and
services to alleviate its severe external imbalances. End

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Government Continues to Keep IMF at Arm's Length

2. (U) Croatia's gross foreign debt stands at roughly 36
billion euros, or 95 percent of GDP. In a climate of
extremely tight credit, the government has been asked
repeatedly in the press in recent weeks how it intends to
come up with the estimated 700 million euros required to
service its debt in the first quarter of 2009. The
government has proclaimed loudly and often that it has no
need of IMF assistance and will be able to raise necessary
capital on the domestic market. Experts with whom we have
spoken are not as confident about the future, but agree that
the government will try to avoid the IMF except as a last
resort. The GoC feels it cannot afford the damage to
investor confidence that IMF intervention might conjure up,
and fears the political battles that IMF conditionalities
might provoke.

3. (SBU) The director of the Croatian Banking Association
(HUB) told us that the government will most likely be able to
manage the situation without IMF assistance. He said an IMF
delegation routinely stops at his office in late fall as one
of their country assessment meetings, but that he had not
heard from them so far this year. He also pointed to the
fact that Croatian banks' assets, along with those of the
central bank, are more than able to cover all deposits in the
country, and the stock of deposits far exceeds the stock of
household debt. Nevertheless, anticipating increased
government borrowing needs on the domestic market in the
coming months, the central bank has reduced the marginal
reserve requirement for Croatian banks.

4. (SBU) The director of the Zagreb Institute of Economics
(EIZ) expects little foreign demand for Croatian government
bonds in the near future. With foreign sources of cash
drying up, the government will be forced to rely even more
heavily on the domestic market to finance its activities.
Fortunately, Croatia has four large pension funds that are
legally obligated to purchase government securities, and the
government has already tapped them to purchase bonds to help
it repay 200 million euro in maturing debt by the end of the
year. A fifth fund, the Croatian Veterans' Fund, is flush
with cash after selling its block of shares in the national
oil company INA to Hungarian MOL and will be a likely
customer for government debt as well. The GoC will also turn
to the domestic loan market which, according to the EIZ
director, carries the serious risk of crowding out of private
sector lending. The HUB director believes this is one reason
for the central bank's decision to reduce the reserve
requirement, in order to free more credit for private sector
lending in the face of increased domestic borrowing needs by
the government.

The Grinch who Stole the Christmas Bonuses

5. (U) For fiscal policy there is very little room for
maneuver in the environment of tight credit, and Prime
Minister Sanader announced on November 12 that the government
would attempt to balance the budget for 2009. To achieve
this aim, he proposed a one-year freeze on public-sector
salaries, including those of employees of state-owned
companies. Without the freeze, civil servants were set to
receive a negotiated six percent raise. Sanader also
proposed foregoing Christmas gifts and cutting back on
entertainment and representational spending, though these
measures would mostly affect this year's budget, not next

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6. (U) Sanader's plan has sparked a firestorm of criticism,
both from unions opposing the idea outright and from economic
experts who say the salary freeze will not be nearly enough
and that the state must put major infrastructure projects on
hold. He has also received a fair amount of ridicule; there
have been caricatures of Sanader in the press as the Grinch.

7. (SBU) Sanader's response to the criticism has been uneven
and tentative. On November 17, press reported that Sanader
had appointed a "brain trust" of economic experts to advise
him on the financial crisis, among them our contact at EIZ.
However, she told us that seeing her name in the newspaper
was the first she had heard of the appointment. The PM
recently also argued semantics, claiming that his proposal
was not a salary "freeze", but rather only a "postponement"
of wage increases. Finally, the press on November 18
announced that the PM had backtracked and was now pushing for
only a six month freeze, followed by reduced raises of 3

8. (SBU) Also named as a member of the prime ministerial
brain trust was the chief economic strategist of the
opposition SDP, Ljubo Jurcic. He told us he was happy to
offer his advice even though Sanader last year told the press
that Jurcic should win a Nobel Prize for idiocy. He said he
planned to tell the prime minister that the truly troubling
imbalance in the Croatian economy was not the government
deficit, but the trade deficit. He recommended putting
big-ticket infrastructure projects on hold (such as the
Peljesac bridge and the arenas for the 2009 World Handball
Championship) in favor of beginning to invest in actual
productive industries that would make Croatia more
competitive in the world. He did not believe a public sector
salary freeze will have much impact except to hurt individual
civil servants.

Economic and Political Realities Hurt Prospects for Balanced

9. (U) The government has not yet released the full budget
publicly, but is holding meetings with unions and employers
to negotiate on Sanader's proposals. The Croatian Employers
Association largely supports Sanader's proposals. The
unions, however, oppose the salary freeze and have suggested
alternative cost-saving measures, such as reducing
higher-level state officials' salaries. They have called on
the GoC to do more to reduce costs for households and
maintain production levels.

10. (U) After a meeting with the unions and employers on
November 17, Sanader told the press budget expenditures in
2009 would increase by 1.5 billion HRK ($270 million) in the
areas of pensions, welfare benefits, and health care. He said
an additional 1.4 billion HRK ($250 million) increase would
be needed for raises if the salary freeze is not approved.
Sanader said the government is willing to negotiate on
infrastructure projects, officials' pensions and other
benefits, as well as managers' salaries and benefits, but
stressed that infrastructure work should continue, as it will
be a key component of keeping GDP growth from falling below
two percent. Analysts have also noted the government will
not want to pull back on announced investments in the energy
sector and other smaller projects for fear of implications in
the local elections scheduled for May 2009.

11. (U) In addition to the political challenge of reaching
agreement on cost-saving measures, the GoC faces significant
fiscal and economic challenges to balancing the budget for
2009. The cost of preparing government administration for EU
accession remains high and, according to analysis by the EIZ,
businesses are increasingly demanding various forms of state
aid. The EIZ analysis indicates that subsidies and other
expenditures--not salaries--have contributed most to
expenditure increases in 2008, and stopping that trend in
2009 will be difficult. On the revenue side, the GoC relies
heavily on the value-added tax for revenue and the slow down
in economic activity will result in poorer collection in

12. (SBU) Comment. Sanader's "cancellation of Christmas"
will probably do little to alleviate whatever risk Croatia
may face from the world financial crisis. As the EIZ
director reminded us, it is not the government deficit, or
even high household debt, that matter in Croatia; it is the
economy's continuing inability to produce sufficient goods

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and services of value to the world market outside of the
tourist industry.

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