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What killed Croatia’s EU accession party?

Dubrovnik, Croatia
Sarah-Jane Joel | Photographer's Choice | Getty Images
Dubrovnik, Croatia

Croatian stocks rallied in the build-up to its addition to the European Union in July this year. But markets have cooled on the former Yugoslav country since then, with membership of Europe's economic and political union failing to counter concerns about low competitiveness and high levels of government debt.

Croatia, which borders Hungary, Bosnia, Serbia and Slovenia, saw its benchmark stock index peak at 2,025 on March 13 this year, after its accession to the EU was announced. Investors viewed membership as integral to making Croatia a safer investment destination, and enabling its access to EU development funds and the free trade market. However, stocks have subsequently fallen around 12.5 percent, with the index closing at 1,771.80 on Thursday.

Henning Esskuchen of Erste Bank, one of the largest banks in emerging Europe, said Croatia had gained from a "kind of marketing effect" prior to joining the EU in July. However, the immediate benefits of membership did not stop the fact that it lagged behind its eastern European peers in recovering from the global economic crisis.

(Read more: Eastern Europe enjoys renaissance as crisis recedes)

"It (the Croatian stock market) had a strong run-up prior to EU accession that has probably given some momentum, which is fair enough. But actually the date itself is a non event, what is important is the process," said Esskuchen, who heads central and eastern European equity research at Erste.

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Croatia fell victim to the impact of the financial crisis later than many of its peers and still remains mired in recession. Its economy is seen contracting for a fifth consecutive year in 2013, and has shrunk by 12 percent over the past five years, according to ratings agency Standard and Poor's. The country has seen a 12 percent decline in real consumption and a 35 percent fall in real investment over the same period.

"Croatia so far has not really been part of the overall recovery in most other markets in the region… Croatia started rather slow and late in reacting to the crisis – now this is kind of firing back and they are one of the last getting out," Esskuchen told CNBC.

The country has also trailed its peers in cutting its budget deficit, even though EU member countries are required to have deficits of less than 3 percent of national GDP (gross domestic product), as well as government debt of less than 60 percent. Instead, its protracted recession has given rise to successive fiscal deficits of 4-5 percent per year and the government does not think it will achieve the sub-3 percent level until 2016.

"In contrast to Poland, Hungary, Czech Republic and Romania, Croatia lacks the fiscal policy anchor that the EU's excessive deficit procedure has superimposed on these sovereigns. Budget projections have consistently been based on over optimistic macro-economic forecasts," said Fitch Ratings in a research note last month.

Fitch downgraded Croatia's sovereign debt rating this year along with rival ratings agency Moody's Investors Service. They view the country's prospects of defaulting on its government debt as higher than before.

The government has attempted fiscal consolidation since coming to power in 2011, but its strategy has focused on boosting revenue through higher taxes and tackling Croatia's sizeable grey economy, rather than cutting expenditure. However, the government has admitted that Croatia's high tax economy means there is little scope for further hikes or the introduction of new levies.

The economy is also hampered by low competitiveness, along with a problematic business environment, a large and inefficient public administration and a lack of labor market flexibility.

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Liza Ermolenko, an emerging markets economist at independent research firm Capital Economics, said that Croatia needed to tackle its high labor costs, reform its labor market, and expand privatization.

"It looks like Croatia's competitiveness problems are at least in part due to the fact that wages are too high compared to productivity, i.e. it is more expensive to produce a unit of output in Croatia than elsewhere. That appears to explain the fact that Croatia's share in world exports has fallen sharply in recent years," she told CNBC.

Ermolenko added that Croatia was also hampered by strong ties to the euro zone's weakest countries. In particular, 15 percent of Croatia's exports are bound for Italy, and Italian parent banks account for around half of Croatia's total bank assets.

"Exports to the euro zone periphery account for over 15 percent of Croatia's total exports, and local banks depend on credit lines from parent banks headquartered in the periphery. But these credit lines have been cut back, which has kept credit conditions tight," she said.

From a stock market perspective, Esskuchen said that high valuations relative to growth meant that Croatian stocks were less attractive than rival eastern European frontier markets like Romania.

(Read more: 'Tiger' of Eastern Europe is waking up: Romanian PM)

"The Croatian equity market is not the most appealing right now… there is no argument for when I should venture into that market particularly given the relatively low liquidity," Esskuchen told CNBC.

—By CNBC's Katy Barnato