Weeks after a close-fought parliamentary election, Croatia is still without a government. Whoever forms the next administration will take charge of an economy that is at last growing after six consecutive years of recession, but which remains in need of serious structural reform and fiscal consolidation if it is to achieve more than its current meagre pace of expansion.

“Croatia is Growing” was the name of the coalition headed by the ruling Social Democrats (SDP), which is the case, but just barely: GDP is expected to grow 1.0-1.5% this year. The SDP’s campaign for the November 8 election focused on the recovery and the threat of cuts if the conservative opposition Croatian Democratic Union (HDZ) got in. The HDZ backed away from early campaign promises of economic reform, falling back on flag-waving patriotism and historical rhetoric, though senior figures assure bne IntelliNews that the party is serious about making improvements to the business climate and fiscal tightening.

In the end, the HDZ-led coalition won the election with 59 seats to Croatia is Growing’s 56 in the 151-seat parliament. But the SDP claims it has the lead once minor parties and ethnic minority candidates that support it are counted in, giving it up to 72 seats.

The kingmaker is almost certain to be the Bridge of Independent Lists (Most), a grouping seen as broadly reformist. Most took a surprise 19 seats, and has demanded a list of specific reforms as the price of its support for any government. At the time of writing, it was leaning toward supporting the SDP, but internal tensions in Most are already apparent.

“The current political situation is promising: the dark-horse party Most is a diverse fellowship, composed of university professors, local level administrators, entrepreneurs, and so on,” Ivan Drazetic, a dealer at Zagreb-based brokerage InterCapital, tells bne IntelliNews. “The party gives reason for optimism since its National Council – the nerve centre – is determined to push for public sector reforms. The very essence of these reforms is unclear, but might be brought to light as coalition building draws to a close.”

The last SDP-led government, headed by Prime Minister Zoran Milanovic, disputes that Croatia suffered six consecutive years of recession from 2009 on, saying that positive figures were recorded in some years. But most analysts and the International Monetary Fund (IMF) disagree. And to address the challenges of the present and future, some understanding of why Croatia has struggled to an even greater extent than its regional neighbours is necessary.

Shock but no awe

“The initial shock [of the 2008 global crisis in Croatia] had a broadly similar pattern as in other CEE economies, where both domestic and foreign demand were adversely affected,” Alen Kovac, chief economist at Erste Bank in Croatia, tells bne IntelliNews. “The later stages revealed more of the structural deficiencies that were a limiting constraint on the recovery process. Competitiveness issues and the narrow export base further trimmed external demand prospects, while domestic demand has been constrained by a lack of structural reforms, elevated uncertainty and the leveraged corporate sector.”

The Croatian kuna’s peg to the euro puts the emphasis on internal devaluation, but the sort of labour reforms and slashing of red tape that might affect this have been absent. The country’s real effective exchange rate (REER) deflated by unit labour costs fell 5% since the end of 2008, compared with a CEE average of 20%, due to poor productivity and a failure to contain wages, Hrvoje Stojic, economic research director at regional bank Hypo Alpe Adria, tells bne IntelliNews.

While other countries in the region have experienced export-led recoveries as the European economy picked up, Croatia was left behind. Exports account for only 47% of GDP, up 12 percentage points from 2009, but still half the CEE average, notes Stojic.

As in most countries in Southeast Europe, there is a sense that the Croatian economy is adjusting to the new realities of the post-crisis world, and that there will be no return in the near future to the type of growth enjoyed in the past decade.

In an April interview with bne IntelliNews, Economy Minister Ivan Vrdoljak said that the government had been painstakingly reorienting the economy towards productive sectors including metals, pharmaceuticals, ICT and electronics, and away from over-reliance on construction – a sector that drove growth in the last decade and crashed hard in the wake of the global economic crisis.

As elsewhere in the region, bank lending also dried up. According to Hypo Alpe Adria, banks’ non-performing loan (NPL) ratios soared to 17.6% in 2015 from 7.8% in 2009 as businesses and some households failed to meet payments; the bank expects the NPL level to rise to 18% by 2017. While the kuna’s euro peg protected banks and debtors to an extent, the $3.4bn of loans extended in Swiss francs rose in relative cost. In September, the government launched a conversion policy for Swiss franc debt to be switched to euros, not dissimilar to that implemented in Hungary and currently being considered in Poland.

“In 2001-2008, Croatia’s GDP grew at an average annual pace of 4.3%, but this was driven primarily by personal consumption receiving a boost from foreign lending,” says Drazetic. “This was also a period of major construction projects, fuelling investment and driving employment. The year 2009 marks a turning point in Croatian economic history, after which inflated personal consumption started to pull back, while the international crisis depleted necessary investment in the Croatian economy.”

Supportive

The government has at least made some changes to attract more of that investment, most notably a new law on “strategic investment projects” that makes criteria for qualification more straightforward. But a range of other factors, several external, has been more significant in supporting the belated recovery. They include the Eurozone recovery, low oil prices, low interest rates and the European Central Bank’s quantitative easing (ECB QE).

Domestically, consumption has been boosted by a record tourist season in 2015 (following a slowdown in 2014), and fiscal relaxation in the run-up to the election. Croatia’s accession to the EU in July 2013 did not provide the immediate fillip that some had naively expected, but Brussels funding is ramping up, and absorption of it is improving. “Nevertheless, it's obvious that EU membership is no panacea for economic woes and structural reforms would have to be implemented sooner or later,” says Drazetic. “Once again I repeat: the sooner, the better. ECB QE can't and won't last forever.”

Stoijics suggest a substantial list of reforms for the incoming government: internal devaluation through lowering business tax and parafiscal and labour costs; supply-side reforms including labour and product market liberalisation; the restructuring of state-owned enterprises and the public administration; and accelerating changes to NPL legislation. Finally, he suggests incentives for financing small businesses and their involvement in the economy. Without such entrepreneurs, Croatia’s long-term growth will remain around 1%, he warns. “The story of Croatian GDP recovery should be a story about boosting competitiveness and attracting FDI,” says Drazetic. “Structural reforms, accompanied by building a more efficient public sector to give more bang for the buck, are just the first step on the path to sustainable recovery. We have a long way to go.”

Kovac argues that fiscal consolidation is essential to secure macroeconomic stability and sustainable growth, but that current plans for tightening lack “mid-term credibility”. While the election result would appear to favour reform, he warns that political fragility could increase. Any coalition is likely to be an uncomfortable marriage of convenience – and Croatians’ appetite for the hard reforms necessary remains questionable.