"While the worst of the recession is over, Croatia is yet to see signs of a sustained economic recovery," said the statement, posted on the website of the Croatian National Bank (HNB).

"To address competitiveness problems, priority needs to be given to structural policies and fiscal consolidation.

"Structural reforms in the areas of labor markets, public administration, and costs of doing business are required to enable a more flexible wage-setting, improve the business environment, and enhance the private sector's role in the economy.

"Croatia's wage levels, which are high relative to both its income and productivity levels, need downward correction to facilitate an internal adjustment given the stable exchange rate regime," the statement said.

Fiscal policy should prevent a further rise in the deficit in 2011, and to enhance resilience against shocks, there is merit to gradual strengthening of foreign exchange reserves, and maintaining strong prudential policies.

"The recovery is expected to be sluggish and medium-term growth prospects are weak," the mission said.

Following a GDP decline of 1.25 percent in 2010, a modest recovery of 1 percent is projected for 2011, inflation is projected to increase to 3.25 percent in 2011, and external financing needs are expected to increase to over 30 percent of GDP.

"Risks to the outlook are tilted to the downside. In the near term, downside risks arise from high commodity prices and contagion from euro area periphery countries," the statement said.

"Upside risks include a more robust global growth, and success in attracting investor interest for infrastructure projects recently announced by the government. In the medium term, EU accession provides opportunities for greater inflows and growth, but would require additional efforts to enhance the absorption capacity," it added.

To correct the long-standing structural problems, the government adopted the Economic Recovery Program (ERP), a comprehensive package of reforms, early last year.

"Measures included in the ERP aimed to address key reform needs, and progress has been achieved in some of the main areas," the IMF mission said, citing the amendment of pension laws and the law on civil service employment, the reduction of non-tax fees by 25 percent, and renewed privatisation efforts.

The mission urged forceful implementation of the remaining key reforms, saying that priority should be given to changing labour laws to induce a more competitive wage setting environment, and to reducing the size of public administration. Other critical actions include improving the business environment through reduction of entry and exit costs and of non-tax fees, and completing privatisation of companies with majority and minority government stakes.

"The mission acknowledges that pursuing these reforms is challenging, but sees them as necessary to reap the maximum benefits from EU accession," it said.

The mission says that Croatia's fiscal position worsened in 2010, urging implementation of additional measures that would prevent widening of the deficit in 2011.

The 2011 budget targets a general government deficit of 5 percent of GDP. With current policies, the mission projects the deficit to reach 5.75 percent in 2011 and public debt 47 percent of GDP (including assumed debt of the shipyards).

The mission recommends keeping the overall deficit (excluding unbudgeted repayments of shipyards' debt due to the sector's restructuring) at its 2010 level in relation to GDP.

"In this regard, it is reassuring that the authorities have identified some contingency measures," the mission said, urging the authorities "to resist any pre-election spending pressures."

The mission welcomed the introduction of the Fiscal Responsibility Law and recommended an expenditure-based consolidation to reach a cyclically-balanced fiscal position by 2016.

With regard to monetary and exchange rate policy, the mission said that foreign currency buffers of the economy should be maintained.

"During the peak of the crisis in 2008/09 and again in late 2010, the CNB (Croatian National Bank) resisted exchange rate depreciation through sales of foreign exchange reserves, and relaxation of foreign currency related prudential measures. Going forward, the mission sees limited scope for the use of such measures given that official reserves are relatively low, and large prudential foreign currency buffers, which were built up before the crisis, have been significantly reduced," the statement said.

"The CNB should aim to gradually strengthen foreign exchange reserves to counter risks from external vulnerabilities. One way to achieve this in a transparent manner would be through small daily preannounced purchases of foreign currency, unless sustained depreciation pressures occur. This would imply an accommodative monetary policy, which is appropriate in the presence of a large output gap and low core inflation. If inflationary pressures emerge or exchange rate expectations become unanchored, monetary policy will need to be tightened," the IMF said.

Regarding the banking sector, the mission says that "systemic financial stability should continue to be safeguarded through strong regulation and supervision."

"Introduction of any additional taxation of banks would need to be coordinated with the EU and carefully designed to avoid triggering capital outflows. The mission understands that a levy on banks is currently not being considered by the government, but periodic reemergence of talks on such a levy creates uncertainty about the operating environment for the banking sector," the statement concluded.