Once the peak of the crisis has passed, it is meaningful and justified to consider past events if their analysis provides lessons on how to avoid or at least minimise adverse effects of potential future crises by efficient and timely measures. For that purpose, the 17th Dubrovnik Economic Conference, organised by the Croatian National Bank, gathered several tens of financial experts from the most relevant international institutions, central and commercial banks, universities and institutes who in the past two days exchanged their experience and research findings as well as resultant conclusions and recommendations.
The global financial crisis has reignited the debate about the risks of financial globalisation, effects of financial shocks on international capital flows, as well as the impact of foreign banks on emerging market financing in crisis periods. These issues are particularly relevant for Croatia and other countries where the major part of the banking system is foreign owned. A research by Dutch authors (Ralph de Haas of the EBRD and Neeltje van Horen of the Dutch Central Bank) shows that in the past period foreign banks financed mostly clients in countries where they had local subsidiaries and where they had gained experience with borrowers, providing continued lending to a domestic economy even under crisis conditions, either through subsidiaries or through direct cross-border financing to domestic firms. Similarly, a research by German economists (Ursula Vogel and Adalbert Winkler of the Frankfurt School of Finance and Management) led to the conclusion that a higher share of assets held by foreign banks is associated with more stable cross-border bank flows during the crisis period, and that a stronger presence of foreign banks is beneficial for a country's financial stability as they perceive host markets which have an EU accession perspective (such as Croatia) as a long-term investment. In other words, the presence of foreign-owned banks in Croatia eased access to international capital flows during the global financial crisis and contributed to the maintenance of stability and liquidity in the Croatian banking system.
An important issue was how banks directed their available funds and how much did credit allocation spur structural changes needed to overcome the crisis and bring about an economic recovery. Results of an analysis by a domestic author (Tomislav Ridzak of the Croatian National Bank) suggest that in the crisis period banks were inclined to grant relatively more loans to firms to which they already had relatively larger exposures, ignoring the prospects for their future performance, which could hamper the necessary restructuring of the economy.
Some analysts considered the relationship between the household and business sector debt level and crisis cycles in an economy (Mikael Juselius of the University of Helsinki and Moshe Kim of the Universitat Pompeu Fabra, Barcelona), holding that the ratio of financial obligations to income can be a useful indicator. When this ratio exceeds the threshold value of 10 percent, it usually portends a crisis characterised by the rise in bank credit losses followed by an economic downturn. Hence, this indicator should definitely be taken into account when assessing the probability of a crisis in each country, including Croatia, and should be used as an early warning indicator for taking macroprudential policy actions aimed at averting the financial crisis and its negative effects on the economy.
Conference participants were also interested in the problem of euroisation (or dollarisation, i.e. substitution of domestic currency by foreign currency), as a phenomenon that has spread over many developing countries worldwide. According to several criteria, Croatia is one of the most euroised economies. The reasons for such a high presence of foreign currency are mostly historical and very complex. The habit of Croatian households to save in foreign currency has been perceived since the late 1960s. Over the last decade, the Croatian National Bank took a number of actions to lower the degree of euroisation. It was successful to some extent; the level of euroisation, measured by the share of foreign currency savings in total savings, dropped from over 80 percent to around two-thirds. However, this trend reversed at the outbreak of the global financial crisis, and the share of foreign currency savings returned to its former levels. Scientific papers presented at the conference addressed complex reasons for currency substitution and related country specifics (e.g. the Czech Republic does not have that problem at all), concluding that currency substitution cannot be stopped by administrative or similar measures. Furthermore, the effects of such measures and administrative restrictions may be just the opposite and even increase the propensity to substitution, considerably deteriorating the confidence in the financial system, with very serious consequences.
As expected, particular attention was given to the discussion on post-crisis challenges for central bankers. As this debate coincided with the completion of Croatia's accession negotiations with the European Union, it was particularly interesting and useful for the Croatian National Bank (represented in the discussion by Deputy Governor Boris Vujčić) to learn about the experience and problems of the countries that have joined the EU but remained outside the eurozone, such as Hungary (represented by Deputy Governor Julia Kiraly), the Czech Republic (represented by the Czech National Bank Board member Lubomir Lizal) and Romania (represented by Deputy Governor Cristian Popa), regardless of country-specific factors of Croatia and each of these countries. Even this discussion could not disregard currency-induced credit risk, which was assessed as potentially very dangerous for all these countries, except for the one with the lowest level of euroisation - the Czech Republic. The situation in Hungary is particularly sensitive as the Swiss franc's share in total loans is close to a high 75 percent. Croatia is the only Central and Eastern European country where foreign currency deposits exceed loans denominated in or linked to foreign currency.
All speakers at the panel agreed that national regulators should not be limited by the EU regulatory framework in designing regulatory measures aimed at specific risks present in their countries and responding promptly to the emergence of new risks. As an example, B. Vujčić mentioned capital requirements for currency-induced credit risks which the CNB had to withdraw to harmonise the legal framework with the EU acquis; he stressed that regulations should be innovative and follow the changes in the financial sector, and that the EU regulatory framework should not prevent regulatory innovations.
Several participants in the discussion, including Jacob Frenkel, former Governor of the Bank of Israel and former IMF chief economist, pointed out that central banks need not be too afraid of domestic currency appreciation. He mentioned the case of Israel, whose export sector adjusted quickly to the shekel appreciation, so that benefits of appreciation outweighed its costs in the final run. Julia Kiraly also believes that an inflation target could have been achieved more easily if the Hungarian forint had been allowed to appreciate more. Lubomir Lizal mentioned the Slovak Republic and said that its entry to the eurozone actually implied a structural reform; along with the highest appreciation, this country has also recorded the fastest export growth.
In their analysis of sectoral data for the 10 new EU members and Croatia in the 1999-2007 period, Reiner Martin of the European Central Bank and Julia Wörz of the Austrian National Bank tried to establish a relationship between market competition and inflation in Central and Eastern Europe. Conclusion: more intense competition favourably affects inflation in many sectors, particularly the food and beverages and housing and utilities sectors. Therefore, economic policy measures to stimulate competition also influence the achievement and maintenance of the desired inflation level.
Based on the analysis of fiscal consolidation plans in the G7 countries, as well as three-year plans for convergence, stability and growth implemented in EU member states, Paolo Mauro of the International Monetary Fund concluded that fiscal consolidation plans based on expenditure cuts were more successful than those based on revenue (tax) increases. It has also been shown that plans were more likely to meet their objectives when they were grounded in structural reforms. Recommendation: in the implementation of fiscal consolidation plans, it is important to define binding limits on expenditures, set cyclically adjusted targets and use realistic macroeconomic assumptions.
Globalisation, financial innovations and deregulation are characteristics of the current financial system which increase its concentration and complexity as well as its exposure to common risks. Deniz Anginer and Asli Demirguc-Kunt of the World Bank examined how these facts increase the risks to the global financial system, and tried to compute the "distance-to-default" measure for individual banks in different regions and worldwide, as well as default risk co-dependence between banks. They conclude that co-dependence increased, particularly in the period leading up to the crisis. For supervisors, this presents the need to strengthen co-operation (regional and wider) and develop common instruments to minimise adverse financial effects that could result from co-dependence.
In such circumstances it becomes increasingly important to recognise timely systemic risk in a country's finances, the risk that could result in a widespread inability of financial institutions to perform their role of financial intermediaries. This is reflected in hampered payments, lending and/or access to deposits of legal and natural persons with negative repercussions to the real sector as well. This is why regulations and measurement of systemic risk have received more attention, inter alia, in the form of stress testing, i.e. assessment of potential losses of credit institutions in crisis situations and their capital adequacy to withstand such losses. For example, the New York University measures and identifies such risks on a weekly basis for 102 US financial firms which are considered to have an important influence on developments in the US financial system. The publication of results on the university's website enhances market transparency and awareness of how important it is timely to recognise systemic risk and take actions to prevent its possible consequences.
From an independent standpoint of an external observer, Paul Wachtel, a distinguished professor at New York University Stern School of Business, recalled how - by coming to the Dubrovnik Conference for years - he experienced the key moments in the development of the Croatian financial system. A lot could have been learnt about the dangers of the banking crisis from the Croatian experience in the late 1990s. However, banks were quickly recapitalised, privatised, i.e. bought by foreign banks, and the period of financial sector expansion began. Noticeable financial deepening occurred in Croatia in the early 2000s. In just a few years, domestic loans to the private sector doubled, standing at 70 percent of GDP in 2006. It was said that financial market deepening provided a major contribution to economic growth. Still, a couple of years later, one could hear that Croatia was undergoing a dangerous credit boom. Nevertheless, the size of the financial sector was not unusual for a country with a medium level of income.
The Croatian National Bank - Wachtel pointed out - recognised well the moment the dangerous threshold was exceeded. The country was no longer going through a positive stage of financial deepening but through a credit boom that could lead to a crisis. Wachtel mentions that even today he does not understand how the Croatian National Bank managed to know the difference, while many other central banks worldwide failed to notice that the threshold had been crossed. The Croatian National Bank introduced innovative changes in the policy to curb credit growth. Credit boom was tempered and the crisis prevented, so that Croatia emerged almost unscathed by the financial system crisis that spread around the world in 2008 and 2009 - concluded this economist of international repute.