Long-term outlook – Fixed Income Research – July 30, 2010

Croatia: July 2010

Changes since previous version

The GDP forecast has been revised downwards, due to the deteriorated investment outlook and increasing risks of
a slower than expected recovery in the EU. The current account deficit has also been revised down to incorporate
domestic demand weakness.

2004 2005 2006 2007 2008 2009 2010 f 2011 f

Real economy
Nominal GDP (Loc. Curr., mn) HRK bn 245,6 264,4 286,3 314,2 342,2 333,1 332,4 344,6
Population mn 4,4 4,4 4,4 4,4 4,4 4,4 4,4 4,4
GDP per capita EUR 7.369 8.043 8.805 9.635 10.766 10.313 10.390 10.758
Real GDP y/y, % 4,2 4,2 4,7 5,5 2,4 -5,8 -1,5 1,5
Private consumption (real) y/y, % 4,3 4,4 3,5 6,2 0,8 -8,5 -2,4 2,3
Fixed capital formation (real) y/y, % 5,0 4,9 10,9 6,5 8,2 -11,8 -8,9 2,5
Retail sales (real) y/y, % 2,5 2,8 2,1 5,3 -0,5 -15,3 -3,5 3,0
Industrial production y/y, % 3,7 5,1 4,5 5,6 4,5 -9,2 0,0 3,5
Prices
CPI, average y/y, % 2,1 3,3 3,2 2,9 6,1 2,4 1,5 3,0
CPI, year-end y/y, % 2,7 3,6 2,0 5,8 2,9 1,9 3,8 3,0
Labor market
Unemployment (ILO methodology) % 13,8 12,7 11,1 9,7 8,4 9,1 10,7 10,4
Gross Nominal Wages HRK 5.982 6.248 6.634 7.047 7.544 7.711 7.730 7.900
Gross Nominal Wages y/y, % 6,4 4,4 6,2 6,2 7,1 2,2 0,2 2,2
External balance
Trade balance % of GDP -20,5 -21,0 -21,3 -22,0 -22,8 -16,3 -14,9 -15,8
Current account balance % of GDP -4,4 -5,5 -6,9 -7,6 -9,2 -5,4 -3,5 -3,9
Foreign direct investment % of GDP 2,9 4,1 7,1 8,6 8,8 4,6 3,4 4,2
Govt. budget balance % of GDP -4,2 -3,5 -2,6 -2,0 -1,8 -4,3 -4,7 -3,8
Foreign debt to GDP % 71,6 71,9 75,1 76,8 85,1 98,3 103,0 104,0
Interest rates
Central bank repo rate, average % 9,50 3,50 3,50 3,60 5,32 6,00 6,00 6,00
Central bank repo rate, year-end % 9,50 3,50 3,50 4,20 6,00 6,00 6,00 6,00
Short term interest rate (3 months) average % 6,84 6,22 4,47 5,59 6,97 8,94 2,65 4,00
Short term interest rate (3 months) year-end % 6,30 5,95 4,60 6,93 8,16 3,75 3,50 4,50
Long term interest rate (10 years) average % 7,37 4,37 4,41 5,18 6,17 7,86 6,30 6,00
Long term interest rate (10 years) year-end % 6,89 4,33 4,72 5,53 6,97 6,63 6,10 6,00
Exchange rates
HRK/USD average 6,04 5,95 5,84 5,36 4,94 5,30 5,46 5,56
HRK/USD year-end 5,64 6,23 5,58 4,99 5,16 5,09 5,29 5,62
HRK/EUR average 7,50 7,40 7,32 7,34 7,22 7,34 7,27 7,28
HRK/EUR year-end 7,67 7,37 7,35 7,33 7,32 7,31 7,30 7,30
Source: CNB, CBS, MinFin, Erste Bank

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Long-term outlook – Fixed Income Research – July 30, 2010

Real economy
After a 5.8% y/y contraction in 2009, GDP shrank an additional 2.5% in 1Q10, signaling that, while the slowdown
has been moderating, economic trends remain sluggish. Domestic demand continued to put in a weak
performance, which was especially visible in the further double-digit investment activity contraction (-13.9% y/y).
Private consumption showed some stabilization, however, remaining well in the negative region (-4.1% y/y). Net
exports once again were a supportive factor, given the export recovery and ongoing import contraction (+3.6% y/y,
vs. -4.8% y/y). For the rest of the year, we expect struggling domestic demand trends, as we do not think that the
corporate sector will start a new investment cycle aggressively and we see investments contracting an additional 9-
10% in the course of 2010. On the other hand, a poor labor market and weak consumer credit and sentiment are
likely to hinder a private consumption recovery. Net exports are expected to remain supportive, given the still
encouraging merchandise account performance and expected rather solid tourist sector performance. With a
weaker than expected investment performance and increasing negative risks related to the export performance, we
revised our GDP forecast downwards by 0.5%, hence anticipating GDP contracting in the region around 1.5% in
2010. For 2011, we see a recovery of domestic demand in the pipeline, albeit a relatively modest one, on a revival
of credit and stabilizing sentiment, helped also by the approaching EU entry in 2012-13. Therefore, in the absence
of any shocks related to the tourist sector performance in 2011, we see GDP growth reverting back to positive
territory within the 1-2% range.

External balance
The current account deficit narrowed substantially during 2009, from 9.2% of GDP in 2008 to 5.4%. 1Q10 figures
additionally confirmed the external adjustment, with the deficit down by a quarter, surprising slightly on the positive
side. As the trade balance figures suggested, the merchandise account was the driver behind the additional
adjustment, with the deficit dropping by a quarter. As far as the remainder of 2010 is concerned, merchandise
account pressures should remain largely subdued, given poor domestic demand and the export side showing some
improvement. The service account should reflect a tourist sector recovery, although likely a mild one. The income
account should continue to be supported by lower profit repatriation, although we see further pressure from the
debt servicing burden. Overall, given the somewhat better than anticipated trade balance performance, we revised
our C/A deficit forecast downwards to the region around 3.5% of GDP. On the financing side, net FDI coverage of
the C/A deficit, after slipping below 50% in 4Q09, returned to above 60% in 1Q. Some additional improvement in
the course of 2010 could be expected, due to the lower C/A deficit and relatively stable FDI. Debt creation should
therefore remain largely related to government financing activities. Despite the relatively modest current financing
needs in absolute terms, strong refinancing needs (in 2Q10-1Q11 close to 32% of GDP) clearly indicate existing
external risks and sensitivity to steady capital flows.

Prices
Inflation pressures have remained at low levels so far in 2010 bringing inflation to below 1% y/y. At present,
demand side pressures clearly remain at a weak level, which is also suggested by the disinflation in 1H (energy
prices excluded). Energy prices are the dominant generator of inflation pressures, supported by the oil price
recovery and administrative price hikes (e.g. electricity) in 1Q. For 2010, the outlook remains benign. Demand side
pressures are not set for a revival yet. We continue to see pressures coming from energy prices and the
administrative price hikes in the pipeline for this year. Administrative price hikes, namely gas and electricity prices,
are likely to produce some spillover effects, though limited ones. Given the base effect, we expect inflation to pick
up towards 4% at the year-end, but on average around 1.5%, further down below the 2.4% recorded in 2009.

Labor market
Official employment office figures indicate that the administrative unemployment rate peaked at 18.4% (+3.4pp y/y)
at the end of 1Q10, bringing the unemployment rate back to 2005 levels and suggesting ongoing labor market
adjustment. 2Q brought seasonal relief, with the unemployment rate declining by 1.8pp to 16.6%, although the
seasonally-adjusted figures are still exhibiting an upward trend. 1Q labor force survey data showed a reversal after
the better than expected 4Q09 figures (LFS UR increased just 0.5pp in 4Q), adding 2pp q/q and standing at 11.2%,
thus better aligning with the administrative rate developments. 4Q observations should reveal more on the labor
market dynamics and potential stabilization of negative trends, but we do not anticipate any reversal of the trend

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Long-term outlook – Fixed Income Research – July 30, 2010

before mid-2011. On average, for 2010, we expect the unemployment rate within a range of 10.5-11% (ILO
methodology), followed by only mild improvement in 2011.

Public sector
The government recently presented its mid-term economic program, aimed at rationalizing the public sector
performance, boosting structural reforms and reforming the judiciary, healthcare and pension systems and overall
supporting sustained public finances in the mid-term. While the program is definitely a step in the right direction, in
the first phase, realization remains slow, burdened by the reluctant government and public resistance to painful
cuts. The upcoming budget rebalance (postponed until autumn) is expected to reveal more on the planned fiscal
gap, as the current 2.5% of GDP gap for 2010 is clearly out of reach, given the underperforming revenue side and
a slight lack of discipline on the expenditure side. The budget rebalance will hopefully reveal more on the effects of
the program on the revenue and spending side and show whether the government will tackle permanent
expenditures, suggesting fiscal consolidation in the coming years. As the rebalance would come relatively late in
the year, maneuvering space for this year is limited. Therefore, we anticipate a deficit in the region around 4.5% of
GDP in 2011. As far as financing is concerned, the government successfully placed EUR 1.85bn (approx. 4% of
GDP) in three bond placements on the domestic and external markets, thus bringing 2010 into comfortable territory
in terms of financing.

Monetary policy
CNB took a breather from further monetary relaxation, as after the 1pp mandatory reserve rate cut at the beginning
of 2010, the CNB remained on hold. Recall, the CNB announced an MRR cut of up to 3pp to provide liquidity for
the government credit stimulus scheme aiming to provide cheaper funding to corporates in cooperation with
commercial banks and the Croatian Bank for Reconstruction and Development (CBRD). However, limited
absorption capacity from the corporate side and overall relatively slow dynamics in utilization of the first tranche of
liquidity resulted in recent words that the CNB would be likely to remain on hold for the remainder of 2010.
Nevertheless, we continue to believe the CNB will be inclined to support corporate credit, given very steady
exchange rate performance and comfortable inflation developments. Therefore, we expect the CNB will continue to
tolerate high excess liquidity as the recent period has shown that a stable exchange rate and ample liquidity can go
hand in hand when market sentiment is stable. Further MRR cuts would depend on corporate demand picking up
and the external environment as rising instabilities would correspond to increased risks to exchange rate stability
and the CNB opting for a more cautious approach,

Exchange rate
The CNB continues to see exchange rate stability as the nominal anchor of monetary policy, and thus its top
priority (also backed by the untouched and increasing FX reserves stock). Recent quarters brought an overall
stable exchange rate performance, hovering in the long-term 7.25-7.35 band, with pressures largely balanced.
The recent period brought intensified pressures on the appreciation side, triggered by government Eurobond
issuance and the seasonal pattern, and also prompting three interventions, with the CNB purchasing approx. EUR
360mn (not allowing the FX rate to head south of 7.20). The exchange rate stability has been supported by steady
foreign debt refinancing, with 100%+ roll-over ratios, a narrowing of the current account deficit and strong
stabilization of market expectations (visible also in the steady MM curve). In terms of the outlook, we remain
confident on exchange rate stability, as the current imbalances should remain at relatively low levels and the major
risks continue to be the lasting turbulence of external environments and the potential inability of the government to
tap external markets (reduced after the recent debt issuance). Therefore, our targeted band remains 7.25-7.45,
with the lower part of the band the more likely.

Alen Kovač
akovac2@erstebank.com
Erste Bank Croatia

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Long-term outlook – Fixed Income Research – July 30, 2010

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