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EU-bound Croatia craves investors but drags feet on reforms

Golf park Dubrovnik project director Ivan Kusalic looks on as he talks to Reuters in Croatia's UNESCO protected medieval town of Dubrovnik A
Golf park Dubrovnik project director Ivan Kusalic looks on as he talks to Reuters in Croatia's UNESCO protected medieval town of Dubrovnik A

By Igor Ilic and Sasa Kavic

DUBROVNIK, Croatia (Reuters) - The barren Srdj plateau overlooking the mediaeval city of Dubrovnik is a real estate developer's dream, offering breath-taking views of Croatia's top tourist destination.

That's precisely why an Israeli-Croatian consortium began planning a billion-euro golf resort there in 2006. Seven years on, construction has yet to start.

This project typifies the problems facing foreign investors in Croatia, which joins the European Union on July 1, more than 20 years after it broke away in war from socialist Yugoslavia.

Worth about 1.1 billion euros ($1.44 billion), Golf Park Dubrovnik has become tied up in red tape, ever-changing municipal building plans and most recently the ire of Dubrovnik's residents.

A referendum in April, forced by civic groups who said the project would spoil the eco-system, failed due to low turnout. But the developers say the damage has been done, reinforcing Croatia's image as hostile territory for foreign investors.

"This is the biggest greenfield investment in tourism in Croatia's modern history," project director Ivan Kusalic told Reuters, standing on the shrub-covered plateau that is still littered with landmines from Croatia's 1991-95 war of independence. "A lot of investors interested in Croatia have contacted us and are watching closely."

Analysts say an over-sized state lies behind many of the problems experienced by such projects. Successive governments have hesitated in cutting the public administration and its employees' socialist-era benefits for fear of losing votes.

In some cases the investment flow is reversing just as Croatia joins the single European market. Some local firms are moving production to neighboring Balkan countries that will remain outside the EU to remain competitive in their backyard.

Foreign direct investment in Croatia peaked at around 4.2 billion euros in 2008, before the global financial crisis fully struck, and had dwindled to a mere 326 million two years later.

It climbed back to 973 million euros in 2012, but these figures pale in comparison with an investment boom over the past decade in the likes of Slovakia, Hungary and the Czech Republic in ex-communist eastern Europe.

Romania, the poorest member of the EU, attracted 23 billion euros between 2006 and 2008.

Slovenia, Croatia's western neighbor and a fellow ex-Yugoslav republic, blazed a trail for the Balkans when it joined the EU in 2004 and the euro zone in 2007. However, Ljubljana is now paying the price of refusing to give up state control over around half of the economy as it tries to avoid an international bailout.

Croatia, by contrast, sold its banks and telecoms and oil firm after independence, but greenfield investments have been few and far between.

RED TAPE, SLOW REFORMS

Tourists, who flock every summer to Croatia's Adriatic coast and over 1,000 islands, account for almost 20 percent of national output. Yet only a handful of communist-era hotels have been sold to foreigners.

Successive governments have dragged their feet on reforms. Scandinavian-style furniture retailer IKEA, for example, had to wait five years to obtain all the necessary permits to open a store in Croatia, and hopes to begin business in 2014.

"Croatia has too many people living off the budget," said Zrinka Zivkovic Matijevic, an analyst at Raiffeisenbank.

"Any serious reform should deeply cut (welfare and public sector) rights and the privileged groups, at the risk of losing the next elections. So far no one has been willing to do that, even though everyone knows what needs to be done," she said.

Weak foreign direct investment has contributed to a recession that has lasted four years. The current Social Democrat-led government has made improving the business climate its top priority to spur growth.

"At the moment we're pursuing 60 different activities aimed at removing investment barriers, primarily to speed up procedures and reduce costs," said Deputy Prime Minister Branko Grcic. "We believe we'll be able to unblock investment projects this year worth around 1.2 billion euros," he said, citing the tourism, industry and energy sectors.

The government also plans to invest 14.3 billion kuna ($2.47 billion) this year in projects including two power plants and an overhaul of the railways.

But the challenges facing the country of 4.4 million people are great. Croatia ranked 84th on the World Bank's 2012 ease of doing business list, dropping four places from 2011 behind poorer Balkan neighbors Macedonia and Montenegro and former Soviet republics such as Armenia, Georgia and Kyrgyzstan.

It ranked even worse in terms of investor protection, property registration and construction permits. It's small wonder that investors see Croatia as a "stagnant and uncompetitive economy", said Naz Masraff, an analyst at Eurasia political risk consultancy.

"It's business environment is less attractive than its regional peers, with an inflexible labor market, high barriers to entry as well as a bloated and inefficient public sector," Masraff said.

Through seven years of accession talks, Croatia worked hard to bring its legal system into line with the EU, arguing to voters that membership was a ticket to prosperity.

But analysts say it has failed to figure out how best to exploit its accession, beyond tapping the more than 1 billion euros in structural funds that will become available each year.

CLINGING TO OLD MARKETS

"In the short term nothing much will change as Croatia failed to attract investors in the years prior to the entry, which was a key for success for many earlier EU newcomers," said Vladimir Preveden, a partner at the Munich-based Roland Berger strategy consultancy. "Most local firms are not innovative and cannot offer much to the common market."

Preveden said Croatia could still prosper if it cut red tape and taxes, eased rules governing hiring and firing, and created a more stable legal framework for businesses.

Corporate tax at 20 percent is higher than in existing Balkan EU members Romania and Bulgaria, which have rates of 16 and 10 percent respectively. Value-added tax in Croatia is 25 percent, one of the highest rates in the entire EU.

Croatian exporters will have full access to a single EU market of 500 million people but where competition is fierce. Sensing tough times, the food industry has already voted with its feet by trying to strengthen its position in neighboring non-EU countries such as Bosnia and Serbia.

Last year, Croatian food exports to the free trade CEFTA zone - which includes Serbia, Bosnia, Macedonia, Albania, Kosovo, Montenegro and Moldova - totaled $709 million, outstripping the $668 million-worth of food exports to the EU.

But from July 1, Croatia loses its free-trade access to CEFTA countries and will end up with the same regime as other EU states, which the European Commission is still negotiating with the Balkan bloc. Some economists assess this could cost Zagreb 0.4 percent of its gross domestic product, or 174 million euros.

Some companies, such as 300-year-old processed meat producer Gavrilovic, have decided to move production across the border to Bosnia to preserve their regional advantage.

"According to our calculations, our products in Bosnia could be between 30 and 70 percent more expensive due to the new customs," said Goran Grbac, senior sales director at Gavrilovic. "Under such a scenario we would likely lose the Bosnian market, something we cannot allow to happen," he told Reuters.

Croatia's main dairy firm, Dukat, has also said it will increase production in Bosnia. Local media have reported tobacco producer TDR, confectionery firm Kras, coffee maker Franck and one of the country's largest food processors, Podravka, could also follow suit. None has said whether it will do so.

"I expect that CEFTA countries will remain the main markets for our food products," said Damir Kustrak, a senior manager at leading food and retail concern Agrokor, adding that established EU markets "are fairly closed for newcomers".

The U.S. ambassador to Croatia, Kenneth Merten, told Reuters he was puzzled why the government, which clearly wanted foreign investments, was moving slowly with reforms.

"It is a question not only we are asking, but many other of Croatia's friends who are already in the EU, people in the European Commission and certainly many in the local chambers of commerce - American, Croatian, Austrian, German," he said.

A Western financial expert dealing with Croatia said Zagreb had no more time to lose.

"There will never again be an investment boom like in Slovakia or Hungary," the expert told Reuters on condition of anonymity. "Croatia will be a different story, based on its location and logistics. But it needs to move faster. Big companies don't wait around. They come and go." ($1 = 0.7642 euros) ($1 = 5.7854 Croatian kunas)

(Additional reporting by Iona Patran in Bucharest and Jana Mlcochlova in Prague; Writing by Zoran Radosavljevic; editing by Matt Robinson and David Stamp)

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