Croatia Defence and Security Report Q2 2009

Croatia's progression towards EU accession has been dealt a significant blow following the decision by Slovenia to veto the opening and concluding of several negotiating chapters on December 19. While Croatia hoped to open 10 chapters and conclude five, the veto has prevented nine from being opened and three from being closed. In order to join the EU, all of the existing members have to ratify the accession treaty. However, Croatia and Slovenia have never agreed their border. Without a settlement between the two nations, Slovenia could potentially hold up Croatia's application indefinitely. Though Prime Minister Ivo Sanadar is confident the veto will be lifted in time for Croatia to complete accession talks in 2009, we caution that this is only likely to occur following a considerable concession on the Croatian side. As a new EU member with an implicit right to veto chapter initiations and closures, Slovenia is now in a more favourable position to negotiate.

Two other main issues remain to be resolved before EU accession: corruption and Croatia’s loss-making shipbuilding sector. The corruption, graft and organised crime issues are particularly crucial. Either a major improvement will have to be evident in 2009, or we would expect that the EU's annual progress report, which is due in November, will not be as positive as the Croatian government is hoping for. It is also expected that the nation’s loss-making shipbuilding sector will need to be privatised, except for the profitable Uljanik shipyard in the northern city of Pula.

Croatia's Defence force will be conscript-free by the end of 2009, and steady force modernisation and downsizing continues despite structural and financial difficulties. Defence spending increased slightly in 2008. It is expected to continue rising through to the end of 2012. The spending trends are: the general reduction of defence spending as a percentage of total government spending; and the continuing reduction – from what was, 10 years ago, a fairly high level – of defence spending as a percentage of GDP. The political nature of the downsizing of the military will likely slow the modernisation process.

Nonetheless, the vast majority of the defence budgets will be taken up with personnel costs and compensation for those who will be included in the army cutbacks. Internal stability remains good, and external security is improving as a result of strengthened relationships with NATO and the EU. Beyond its problems with Slovenia there is little threat of conflict for Croatia. Overcoming the challenges related to border control is a high priority for Croatia in the context of its drive for EU membership. Improved regional co-operation and border security are therefore policy priorities.

The latest GDP data release for Croatia shows the economy continuing to slow during the third quarter, further confirming that the economic downtrend is now firmly in place and will continue to play out through 2009. The deterioration in trade dynamics, unwinding of domestic demand, and contraction in external credit availability constricted growth dynamics during the third quarter, with the economy only mustering up growth of 1.6% y-o-y, down from 3.4% the previous quarter, and marking a multiyear low.

Given the severity of the slowdown in the third quarter, and our belief that both domestic and external demand conditions will get worse before they get better, we have revised down our economic growth forecasts for 2009 and 2010. Specifically, whereas we were previously targeting growth of 2.1% in 2009, we now expect to see a contraction of 1.5%, coinciding with the deepening of the eurozone recession (with growth of -1.6% currently pencilled in). Moreover, given our belief that international credit markets will still take time to thaw from their current state of flux, and that risky emerging markets such as Croatia will come further down the priority list of international lending, we do not expect to see a swift return to pre-credit crunch levels of economic growth. As such, we forecast a mild recovery to 1.3% growth in 2010, ticking up further to 3.2% in 2011.