Chickens come home to roost
In late 1993 the Croatian government instituted an economic stabilisation programme that was extraordinarily successful in curbing hyperinflation. But it led indirectly to the creation of a pension debt that delayed the introduction of a second and third pillar and more than a decade later threatens the country’s fiscal stability and the current government’s majority.
In October 1993 Croatia was half way through what it calls its Homeland War, the 1991-95 conflict that followed its declaration of independence from Yugoslavia. A UN-sponsored truce was holding but Serb forces were left occupying substantial tracts of Croatia’s territory, the shelling of Dubrovnik the previous summer ensured there were no chances of reviving tourism income and hyperinflation was peaking at more than 1,000%.
The government’s response, an economic stabilisation programme that brought inflation down to 4% in just one month and reduced it to 0% by the end of the year, was threatened by the system of pension indexation that Croatia had inherited from its years as part of communist Yugoslavia. It was full wage indexation, with pensions being linked to the wage growth of two months earlier, that being the minimum period required to publish the data.
“Pensions were trailing somewhere around 60% replacement rates,” recalls Zoran Anusic, senior economist at the World Bank regional office in Zagreb and a veteran of the reform process. “Had the government continued with this indexation with a two-month time lag when inflation dropped almost to zero over a month, the replacement rate would have reached something like 110%.”
“The war plus a transition to a market economy, gave rise to a major drop in employment in the 1990s while the number of pensioners increased rapidly,” said Damir Bakic of the university of Zagreb’s mathematics department and a former member of the managing board of the Croatian Pension Institute. “The system had a loose definition of eligibility for early retirement, survivor’s pensions were paid to those wounded in the war and to families of soldiers who were killed and rights were extended to various groups of former political prisoners. As a result the ratio of workers to pensioners was only 1:1.5 in 1998 and 17% of pensioners had been awarded privileged benefits.”
The prime minister of the day, Nikica Valentic, responded with a government decree that in essence introduced pure price indexation. The stability pact was secured and has ensured that since 1994 the Croatian inflation rate has been among the lowest among the transitional economies.
But an oversight by Valentic the following year has overshadowed Croatia’s pension system ever since, delaying his government’s pension reforms and threatening the fiscal policies of successive administrations. Under the Croatian constitution a government decree expires after 12 months unless the measure is subsequently passed into legislation. But instead of implementing wage indexation through a parliamentary law, the Valentic government simply issued another decree when the first expired.
The laxity was characteristic of the political environment of the time. Valentic’s administration was drawn from the Croatian Democratic Union (HDZ), a party formed by then-president Franjo Tudjman. Seen as the father of Croatian independence, Tudjman attracted less international censure than his Serbian contemporary Slobodan Milosevic although he pursued an equally rampant nationalism abroad, followed an authoritarian domestic policy that included keeping a tight rein on the media and the manipulation of the electoral process, and concentrated power in the hands of a small oligarchy including members of his own family.
However, Valentic’s second decree was challenged by the Constitutional Court which ordered the reinstatement of wage indexation and repayment of the difference to affected pensioners for the 1993-98 period.
The government responded with half measures. The Constitutional Court suit coincided with the preparation of a pension reform. By 1997 it had become clear that urgent measures were needed to prevent the collapse of the pension system and in 1998 the government passed the pension insurance law that introduced parametric changes to the first pillar and laid the basis for a mandatory second and voluntary third pillar to relieve pressure on a budget deficit that had ballooned during the war and in the face of growing healthcare costs. But the government avoided tackling what became known as the pension debt problem.
Meanwhile, the Constitutional Court had challenged another HDZ initiative that must have seemed a good idea at the time. In an attempt to relieve fiscal pressures the government had not transferred the correct amount to pay the pensions for the military and other privileged categories that should have been paid directly from the budget and instead had diverted contributions from the pensions system, cutting pension payments by basing them on wage indicators that were different from those published by the statistics office.
The court again ruled that the correct system should be restored and the shortfall repaid. The government responded to this second challenge with the so-called ‘small law’ restitution that granted limited retroactive payments.
“In 1997, just before the 1998 reforms, the government passed legislation that reintroduced price indexation but it left the 1993-98 problem open,” says Anusic. “The following year it realised that the implications of the Constitutional Court ruling on the pension debt would be devastating for both current fiscal policy and public debt so it chose to respond with what it called an ‘administrative silence’, giving no reply whatsoever, it did not even want to touch the issue.”
The government’s silence was exploited by the opposition Social Democratic Party of Croatia (SDP). Tudjman had died in 1999 and in the 2000 general election campaign the SDP raised the pension debt issue and promised to repay it. However, it appears not to have considered the economic impact of the pledge.
“What the HDZ did with the decree was a stupid mistake,” says Davorko Vidovic, former SDP minister of labour and social welfare with responsibility for pensions. But he is defensive about his own party’s exploitation of the question. “We raised the issue because we had an obligation to do so,” he says. “There was a Constitutional Court ruling so we had to do something. And we found a method by which we could give back the money to the people in a reasonable time and in a way that would not put too much pressure on the state budget. We said that we did not owe the money to the people but to the pension institute, and we had to put the money into the institute so that it could disburse it to the pensioners. We estimated the debt at around HRK24bn, that’s about €3.5bn, calculated how much every person on a pension should get, and increased the pensions accordingly. So we had some 1m pensioners and of those 770,000 got a 20% increase. After than we considered the problem solved.”
“The SDP-led administration took a year to formulate a way to redeem this promise,” notes Anusic. “The first article of the law that increased current pensions by 13-14% claimed that the measure represented the final repayment of the debt. The move effectively added expenditure of about 1% of GDP to the budget each year, and this still continues.”
This process delayed the introduction of the second pillar that had been laid out in legislation passed in 1999 by the outgoing HDZ government in the teeth of opposition from the parties making up the new government. “The SDP and its allies voted against the first integral law and abstained on the law on mandatory and voluntary funds,” says Anusic. “But this was not due to disapproval of the concept, which ultimately they implemented in 2001, but was more in line with the parliamentary environment of the time when they voted against any proposal coming from the HDZ government.”
The second half of 2001 and the first half of 2002 was taken up with technical preparations for the starting of the individual accounts, the formation of the second pillar clearing house, the Central Register of Insured Persons (Regos) and the removing of political appointees placed by the HDZ government in the regulator, the Pension Funds and Insurance Supervisory Agency (Hagena).
Both institutions have turned out to be success stories. Regos undertakes the back office function, relieving the funds of the responsibility and expense of collecting contributions. It also prevents any conflict of interest between employers and fund managers. “The government wanted to prevent an employer being able to exert pressure on his employers to choose a particular second pillar fund,” says Anusic. “So instead of the employer being involved in any stage of the contribution process the emphasis was placed on each second-pillar participant.”
Members sign up with Regos and not a fund salesmen and it provides an infrastructure allowing participants to choose a particular fund without anybody on the chain knowing what the choice was. The same goes with switching. “Those who want to switch contact Regos, fill in a form and nobody knows they have switched from one fund to another,” says Anusic.
Lower costs are reflected in the fees that Hagena allows the funds to charge, which are capped at an entrance fee of 0.8% and a management fee of 1.2%.
Money started flowing into the individual accounts in 2002. Mandatory pension contributions are set at 20% of a gross wage, with 15% going to the pay-as-you-go fist pillar and 5% to the funded second. Over their three years of operation, the four funds, down from an initial seven, have collected HRK8.5bn.
But the success of the funds was not reflected on the result of the 2004 general election.
The parties making up the government, which spanned the political spectrum from the former-communist SDP, through regional interests to the centrist Croatian People’s Party and liberals, opted to fight the campaign separately.
“That was a mistake,” concedes Vidovic. “Despite getting the same number of votes as in 2000 when we fought all together and indeed getting 150,000 more votes than HDZ, we lost. Ours was the first coalition government in the history of Croatia, so people had no experience of it and consequently even petty differences between parties were seen by the public as major disagreements. Public opinion held that we were only squabbling all the time.”
The election had denied the HDZ a majority and in a replay of the electoral opportunism that had seen the SDP open the pension debt problem before the 2000 election, in 2004 the HDZ courted the support of the Pensioners’ Party (HSU), which had gained three seats, by claiming that the SDP-led coalition had failed to resolve debt the issue. And it gave further concessions.
“It agreed to recalculate and repay all the debt, reverse the Swiss indexation which averages price and wage inflation and had been introduced by the 1998 pension law for the first pillar and return to wage indexation, include the supplements from the ‘small law’ amounting that had been due to end in 2004 into the regular pension, promised to raise replacement rates to 50% in 2005 and to 70% afterwards and agreed with the Pensioners’ Party that the impact of the pension reform should be reviewed and the concept revisited, whatever that meant,” says Anusic.
In addition, the government enacted a law in 2004 establishing a pension restitution fund into which it will transfer the equity of state-owned property and has spent the past months negotiating with the Pensioners’ Party which assets should be transferred. Already some 50-60 enterprises, including some blue chips, with assets totalling some HRK10bn, have been earmarked for the fund.
“The debt problem has two main aspects, the flow and the stock issues,” says Anusic. “If somebody’s pension was under-calculated in the 1990s, their current pension should be higher – the flow issue. But also the past unpaid pension should be repaid — the stock issue. The fund is intended to repay the stock. There is a third question, that of the interest rates on the money not paid, so while governments have partially tackled both of the other problems, none has tackled it in the integral manner.”
The size of the stock debt has not yet been calculated but current estimates put it close HRK20bn, or 9% of GDP, although at the time of the previous HDZ government’s ‘administrative silence’ some calculations put it two or three times higher.
And the diversion of privatisation revenues to the debt issue has serious implications for fiscal policy because the Croatian budget has relied heavily on privatisation proceeds. Total debt now stands at 80% of GDP, with public debt being 55% of GDP, and at this level it could have repercussions on Croatia’s ambition to eventually meet the Maastricht criteria.
Consequently, the government has been rowing back on the pledges. It has announced that it will reverse its decision on indexation and restore the Swiss method, and that it will not apply further increases to pensions.
Despite the HDZ government’s dependence on the HSU, industry insiders say they see no immediate risk in this strategy if only because of one of the most compelling of political motivations – self interest. “We don’t see any immediate threat for the simple reason that it is in all parliamentary deputies’ interest not to provoke early elections before 2006,” says Senka Fekeza Klemen, director of the ERSTE Voluntary Pension Funds Management Company. “According to the law, deputies can only receive a parliamentary pension after spending two years in the Sabor, which means they will have to wait until December 2005 to break up current coalitions and look for better partners. This is especially tricky issue given that none of parliamentary parties is strong enough to form a government without entering a coalition with at least one other party and with the population’s political preferences changing rapidly, no party is willing to take risks.”
But Vidovic thinks that the new strategy will cost the HDZ the support of the HSU and that an early election will follow. “The next election is due in two and a half years but we think it will be next spring as this government will lose its parliamentary majority and collapse before the end of its term,” he asserts. And he is optimistic that the previous SDP-led alliance can be recreated. “We have learned from our mistakes in the last general election and will fight the next election as a coalition,” he says. “Now, public opinion polls show that for the first time the SDP has more support than the HDZ. It’s a new situation, and we feel that if there are early elections we will win.”
And to be on the safe side the SDP is also in coalition talks with the HSU. “I expect it,” he says. “Zagreb is already governed by a coalition of the SDP and the Pensioners’ Party, and Zagreb is half of the country.”
But in an indication of what this might mean for the pensions issue Vidovic says he would like a change of job in the next cabinet. “I would not want to be minister of labour and social affairs again because this pensions issue cannot be solved easily, it will take more time and new methods to solve it,” he says.