By Martin Santa
BRUSSELS (Reuters) - Croatia may have to go straight into an EU disciplinary procedure when it joins the bloc in July and face an even tougher haul than its ex-Communist peers in adapting to free market pressures.
Croatia will become the European Union's 28th member state and only the second entrant, after Slovenia, of the republics that emerged from the Yugoslav wars of the 1990s.
But after four years without growth and only limited efforts to reduce the state's role in the economy, debt and budget deficit levels breach EU limits.
A European Commission paper, issued last week alongside others on current EU member economies, suggests Croatia will have to be put under formal EU scrutiny almost as soon as it enters the bloc on July 1.
Croatia, accepted for entry after six years of talks, will follow in the footsteps of 10 other ex-communist states. Of these, the Czechs and Slovaks privatized major state-run banks and companies before they joined and sold off more after entry.
Slovenia, which joined the EU in 2004 in global boom times and adopted the euro in 2007, failed to sell off major state-owned banks and is only now trying to sell to avoid an international bailout.
Croatia, like Poland and Slovakia, has introduced a private pension scheme but has more to do to get its finances under control, the Commission said. Slovaks adopted the euro in 2009 which helped to strengthen investors' confidence further.
Zagreb's EU membership has raised hopes for a surge in foreign direct investment in the 44 billion euro ($57 billion) economy, boosting growth and employment.
The Commission, however, warns of Croatia's widening budget deficit, soaring public debt and generally uninviting business environment, dented by lack of competition, poor legal protection for investors and a weak public administration.
"Croatia faces important challenges in terms of reviving growth, strengthening public finances and promoting competitiveness," the Commission wrote.
"Continued high government deficits are contributing to a rapid build-up of public debt," it said, mentioning the drag on finances from loss-making state enterprises, as in Slovenia.
Croatia's debt is expected to rise to 62.5 percent of gross domestic product (GDP) in 2014, up nearly 10 percentage points from 2012 and breaking the EU's 60 percent official ceiling.
The budget deficit is forecast to widen to 4.7 percent of GDP this year, from 3.8 percent in 2012, and unless unchecked to 5.6 percent next year - all above the 3 percent EU ceiling.
The equation has been skewed by an economy that has been shrinking since 2009, when it contracted 6.9 percent. The Commission expects a 1.0 percent decline this year and growth of just 0.2 percent in 2014.
As a result, European officials may decide to put the country's finances on immediate watch come July.
"The Commission will assess the situation and examine whether an excessive deficit exists," said one official, adding that there was no timetable for action at this stage.
Croatia may yet have a chance to reignite growth and employment if it can follow Slovakia, the Czech Republic and Poland in pushing through unpalatable reforms and levering off cheap labor costs to attract foreign investment.
But Croatia, like Slovenia, needs to speed up the privatization of loss-making state-run companies, improve tax collection and clamp down on fraud, the Commission said.
(Reporting by Martin Santa; editing by Luke Baker/Ruth Pitchford)