1. A year ago, the Croatian economy grew at an annual rate of 4.3% (approximately the same as in the previous seven years), whereas a need for an even faster growth was discussed at various professional and political forums. The necessity was emphasized for investment growth, job creation, stronger incentives, the development of people's share ownership, house building as a growth generator, the strengthening of the welfare state, etc.
Nowadays, the economy slumps at a rate of 6,7%, and the main issue is how to mitigate the effects of the global crisis spillover to this country and after that, to resume the previous upturn within the general economic recovery.
Both of these approaches are wrong. Only a year ago, the obvious dangers of the economic growth were underestimated, whereas now the reestablishment of the pattern which only heightens the effects of the global crisis spillover to the Croatian economy and its trends is coveted.
As if this had taught us no lesson, and as if nothing could be learned from it.
And the lesson is that long-term growth cannot rely on domestic demand expansion which permanently generates profound internal and external imbalances, thus increasing general indebtedness. As a matter of fact, its growth has also enhanced the risk that potential problems with the inflow of capital, the growth of its prices or problems with monocultural export supply might disrupt the entire pattern of growth and reverse it completely. And this is exactly what happened.
Consequently, the way out of the present situation cannot be to further widen the imbalances, but to reduce them significantly, even if there were no long-term restrictions on their further financing, and even more so where such restrictions are very rigid in the short run.
Therefore, it is generally necessary to apply an “anti-cyclical economic policy" based on a healthy core and built-in shock absorbers. As there has not been such an integrated policy so far, we are now in a situation that we must reduce deficits in the midst of the recession, which can further aggravate it.
2. The genesis of this problem is well known from the experience of some other countries where strong foreign capital inflows and credit expansion exerted a powerful influence on goods and services markets, as well as the securities and real estate markets. In the former case, the credit-supported demand for goods and services exceeding the short-term domestic supply capacities was satisfied by stronger import- based supply, which led to an increase in the current account deficit, but also helped maintain the relative price stability on these markets. Naturally, this was not the case with the financial market, where supply was much more restricted so that the growth of demand (additionally financed on the basis of individual preferences for converting a portion of domestic savings into capital) resulted in a considerable price increase, which finally produced a pure bubble effect. This in fact led to a vicious circle in which credit expansion, supported by optimistic expectations, resulted in an asset price increase, providing an incentive to investors and raising the prices of collateral, which all together further encouraged credit expansion.
Thus, strong credit and investment growth, as well as rising prices of securities and real estate coincided with relatively low inflation measured by the consumer price index. As this process was also connected with the real growth of economy, it increased preparedness for taking risks, thus giving further impetus to the credit cycle. Vice versa, after the change of expectations about the risks and return on investment, caused by both internal and external factors, the entire process took the opposite direction and prices plunged, negatively affecting the real sector which is currently burdened by a huge debt and low investment activity.
Such capital flows also had a strong impact on changes in monetary systems and monetary policies in general, particularly in small, highly euroised economies. These policies were no more based on fully endogenous creation of money supply by central banks which, through an interaction with demand, target the general price level, exchange rate and interest rates. In contrast to this “neoclassical” scenario, in an environment of liberalised financial flows, monetary policy, as a kind of a “filter”, has through the interrelationship between relative prices and returns, influenced capital inflows into and outflows from the country's financial system, thus acting as a moderator of the general economic performance.
This capital has its benchmark foreign interest rate and its conversion into the domestic currency has an appreciation effect on the exchange rate.
Being aware of all this, the CNB has, for a number of years now, emphasized high risks facing the Croatian economy in the globalised financial system, i.e. the risk of transferring potential external shocks, as well as internal shocks caused by the processes initiated or supported by foreign capital inflows in an environment of relatively low disposable income and a high propensity to consume in the country.
Therefore, the primary task of the CNB's policy in the previous years was to regulate the inflow of capital into the banking system in such a way that it supports, rather than impedes sustainable economic growth through its unchecked expansion. In doing so, it had to be borne in mind that all large banks in Croatia actually operated as financial conglomerates, and as such, they directed the employed foreign capital and alternative forms of domestic savings to the markets, with a view to maximizing returns at the conglomerate level.
Under such policy approach, in selecting monetary policy instruments priority was given to those which made the banks' external sources of funds more expensive and limited their credit multiplication, i.e. which, ultimately, reduced high rates of return on bank capital, being the main motive for aggressive credit supply.
To this end, the CNB has primarily applied, and gradually tightened, direct influence measures (marginal reserve requirement on foreign borrowing, compulsory purchase of CNB bills in case of excessive growth of bank placements, minimum required foreign currency claims and maintaining a high reserve requirement rate), and, complementarily, prudential measures aimed at maximizing the effects and reducing the linearity of direct measures.
Of course, such policy was not readily accepted by banks and very often by some political agents. And not only by them! International financial institutions have precisely anticipated the risks arising from expansionary foreign capital inflow, but have given preference to prudential and market-oriented monetary policy solutions, emphasizing the long-term damages of "administrative" measures.
The CNB's ability to resist these pressures at the onset of the global financial crisis had two positive effects. First, while the Croatian monetary policy has never been really restrictive in the way that insufficient money supply would limit economic growth, it has still significantly impeded the growth of credit and foreign debt, and consequently the growth of credit liabilities of the corporate and household sectors, relative to what it might have been without such policy. And second, the application of the "administrative" instruments made it possible to create liquid reserves at the entire banking system level, which served as the necessary shock absorber when the external shock occurred.
3. The crisis awareness heightened in Croatia during October 2008, due primarily to the stock market crash which was expected to end in a large-scale financial collapse.
However, this did not take place, thanks to a prompt and efficient reaction on the part of the monetary system, based exactly on the principle of anti-cyclicality. At that moment, it was crucial to prevent the loss of saver confidence in the banking system and maintain monetary policy credibility. Without this, the "vicious circle" of the financial crisis would be set in motion, described by Paul Krugman as the interdependence of three elements causing the loss of confidence — exchange rate depreciation, the growth of interest rates and a slump in demand — which results in financial problems for enterprises, banks and households that lead to further erosion of confidence.
Although all these elements were, and in part still are, present, the intensity of their manifestation has been kept at a level preventing a chain reaction.
For this purpose, the CNB repealed the marginal reserve requirement (effect: EUR 450m) and reduced the general reserve requirement rate from 17% to 14% (effect: EUR 1,115m), thus releasing EUR 1,555m of immobilized liquidity in to banks. Moreover, by lowering the rate of minimum required foreign currency claims from 28.5% to 20%, it provided the banks with a possibility to use their reserves in the amount of EUR 2,084m. Further monetary and prudential measures included increasing the allowed open foreign currency positions of banks, concluding swap agreements and interventions in the foreign exchange market (net effect: EUR 200m), which additionally improved the mobility of liquidity within the banking and financial systems.
Concurrently, banks' external debt increased by EUR 2,131m in the fourth quarter of 2008 (short-term debt rose by EUR 1,898m). As a result, total net liquidity input by the CNB and foreign banks (450 + 1,115 + 2,131 + 200m) reached EUR 3,896m or about 8% of GDP.
One third of these funds were directly or indirectly transferred to the government for the settlement of domestic liabilities and external debt repayment, and the rest was used for maintaining the liquidity of banks' transactions with other sectors.
4. After this initial shock, the monetary situation gradually stabilised, but its structure and dynamics changed markedly. 4.1 The most serious potential risk of the global financial crisis spillover to Croatia is considered to be the risk of a partial withdrawal of foreign capital from the country by reducing bank deposits and investments in funds, paying out profits or failing to refinance due external liabilities of enterprises and the government.
As this has not happened so far, gross external debt stood at EUR 39.8bn at end-April this year, 1% above its level at the end of 2008. Corporate debt and direct investments rose by about EUR 750m, whereas the central government reduced its debt by EUR 610m, c That, in addition to continuing to refinance its liabilities by borrowing on the foreign market.
Under the current circumstances, when there is no reliance on an arrangement with the IMF or any other form of external financial support, this certainly represents a positive development, but also a sign of a radical cessation of the current trend in foreign capital inflows through the credit channels. Only in 2008, these inflows, representing the main source of domestic consumption and investment financing, stood at EUR 6.4bn (up 19.6%).
4.2 After a sharp fall in household bank savings, by about HRK 3.5bn, during October 2008, they returned to the previous level in real terms, by the end of the first quarter of 2009, and even increased by 8.3% in May relative to the year before. This resulted in an annual increase in total savings by 6.1%. However:
(a) The growth of domestic bank savings is now two times slower than the previous years' average (13.5%) and is influenced by the substitution by alternative forms of saving. As a result, the aggregate value of domestic financial assets declined markedly.
(b) Owing to a heightened awareness of the currency risk, the share of foreign currency savings in the total savings structure increased from 66.9% in May 2008 to 72.9% in the same month of the current year. This also raised the level of euroisation of the Croatian economy in which the share of foreign exchange assets in total liquid assets rose from 50.0% to 56.4%.
(c) In contrast to household savings, corporate sector savings declined by 5.0% over the last year, their share in the total savings structure dropping from 18.7% to 16.7%. This is a sign of a marked weakening of this sector's financial potential, reflecting reduced liquidity in the current operations, where the amount of deposit money decreased by 16.9%, causing an 11.0% decline in money supply.
4.3 All this points to strongly restricted growth of the potential of domestic sources of credit, connected with external debt and stock exchange stagnation, as well as to the constrained development of the country’s total financial potential.
Immobilized liquidity reserves, still maintained by the CNB, were markedly depleted over the last year (having dropped from HRK 53bn to HRK 42bn), with banks' foreign currency reserve requirement standing at a low of EUR 633m at end-May (compared with EUR 2.4bn in the same period last year). Accordingly, any further reduction of the reserve requirement rate would hypothetically facilitate only domestic payments, whereas the conversion of thus released domestic currency into a foreign currency would require a significant depletion of the central bank’s net foreign currency reserves, which would have a negative impact on the perceptions of domestic savers and foreign creditors. Such a move would therefore only be justified in the case of a credit crunch on the foreign markets, or an explicit threat to the country’s external liquidity position.
4.4 Thanks to a strong liquidity injection from foreign banks and the CNB, total bank placements maintained their average annual growth rate of 13.2%, from the previous five years. However:
(a) Out of total loans, net loans to the government rose at a rate as high as 109.6% over the last year, their share in the total structure of bank loans increasing from 6.3% in May 2008 to 11.7% in May 2009.
At the same time, loans to other sectors have grown at an annual rate of 6.7%, decelerating considerably from 10.5% in 2008 and 15% in 2007. As a result, the difference between the effective growth of loans to these sectors and that not sanctioned by the CNB has increased. Specifically, these loans have gone up by 10.1% relative to the stock at the end of 2007, whereas the "limit" is set at 17%, allowing for an additional HRK 14.5bn. Although partly resulting from a slowdown in loan demand, caused by an interest rate increase and uncertainty, this is also an indication of the government's strong crowding out of other sectors from the loan market.
(b) The increases in the foreign sources of funds and in the share of foreign currency savings have shortened the foreign exchange positions of banks, whose net foreign liabilities have increased from EUR 3.9bn to EUR 5.4bn (while net foreign assets of monetary institutions have dropped from EUR 6.1bn to EUR 3.4bn). This has resulted in an increase in currency risk, which has led some banks to stop granting "pure" kuna loans, transferring this risk to new loan users. That, in addition to a rising level of euroisation, has underlined the importance of maintaining a stable exchange rate.
4.5 Under the impact of an increase in foreign exchange demand, the kuna exchange rate depreciated by 2% in the first quarter of this year, subsequently regaining a relatively high stability due to weakened depreciation expectations and government foreign borrowing.
In an effort to curb depreciation expectations, early in 2009 the CNB intervened directly in the foreign exchange market with a gross amount of about EUR 500m, but it also relaxed prudential measures in order to leave more manoeuvre room for banks to increase their foreign exchange supply and take their own part in defending exchange rate stability.
Banks were provided the needed "incentive" by a change in the currency structure of reserve requirement allocation and by the policy of providing limited kuna liquidity injections through open market operations, which periodically led to sharp increases in interest rates on overnight loans in the money market. As the exchange rate stabilised, the pressures on these rates reduced, with the result that they have constantly stood below the CNB Lombard rate, averaging 6.5%.
4.6 The relaxation of monetary policy has also resulted in an approximate reduction of 20% in banks' "per unit regulatory costs". For example, to cover these expenses with an interest rate on a foreign currency deposit of 5% and exchange rate risk of 2%, banks used to require an average interest rate on placements of 10.2%, whereas this rate has now been reduced to 8.1%.
The fact that bank lending interest rates have nevertheless grown is due to an increase in the price of foreign borrowing (country risk), a rise in interest rates on domestic deposits, triggered by the strengthening of bank competition against the background of a slowdown in deposit growth, and the worsening of placement quality, that is, a decrease in the recovery rate for loans, especially those granted to households. This has been accompanied by a marked slowdown in bank lending to the private sector, which, within the overall volume-to-price ratio, resulted in a decrease in the ROE of banks from 10.93% in 2007 to 9.91% in 2008 and 9.32% in the first quarter of 2009.
5. Therefore, taken as a whole, the monetary sector has withstood the first impact of the financial crisis and it has been consolidating. However, it has lost its capacity to support the growth dynamics of aggregate demand exhibited so far, and banks themselves are not ready to continue with unselectively pursuing an expansive credit supply policy.
By contrast, the real sector downturn has not yet come to a halt. This downturn, however, is not only a consequence of the current financial crisis, but also of the gradual accumulation of several factors, and it had started already in early 2008. Specifically, industrial production has been declining at an average trend rate of 0.7% a month ever since March 2008 and GDP practically stagnated throughout the previous year at the seasonally adjusted level reached in the last quarter 2007.
The causes for this include: (1) An acceleration in the average annual inflation rate from 2.9% to 6.1%, which in 2008 offset the bulk of the nominal current income growth. Notwithstanding an aggregate decrease of about 1% in consumer prices in the second part of 2008 relative to their July level, the current growth in these prices, standing at 2.8% in the first five months of 2009 (compared with a low of 0.6% in the EU) is an indication of the possible continuation of inflation's negative effect on disposable income and real domestic demand.
This has partly resulted from an increase in input costs, but also from a prevailing perception of economic policy as creating room for price increases in some products and services or "removing price disparity", even if these products are internationally traded, and especially if they are not. All this points to the fragility of relative price stability and indicates how easily it can be undermined, even in recession conditions.
(2) A decrease in the value of household financial assets invested in securities and non-banking institutions, caused by bubble bursting in equity and real estate markets. This decrease, amounting to about HRK 43bn (37.1%) in 2008 and including an approximate drop of HRK 16bn generated in the fourth quarter, almost completely offset the increase in the value of these assets in the previous year. Coupled with a real stagnation in employment income, such a loss of capital income and liquidity has led to a slump in personal consumption and sharp investment slowdown.
(3) An increase in illiquidity stemming from the inelasticity of a part of current expenditures under the conditions of a revenue drop and high loan commitments. And while the household and corporate sectors have secured some room for manoeuvre through cuts in their savings, the government sector has behaved in a very rigid manner. Specifically, the consolidated general government deficit (inclusive of the HAC and CBRD) widened from HRK 5.6bn in 2007 to HRK 9.1bn in 2008, or from 1.8% to 2.7% of GDP, with its whole amount concentrated in the fourth quarter, when the financial market turmoil was at its highest.
Similar trends continued in the first five months of 2009, when the central government net borrowing increased by an additional HRK 13.3bn, of which HRK 10.5bn was in the domestic market (this is in contrast to the stagnation of other sectors' debt to domestic banks in that period).
Initial domestic market liquidity in that period was definitely insufficient to finance such government needs, so that the government's insolvency, that is, its inability to settle its liabilities — especially foreign liabilities — could have only been prevented by an informally "conditioned" relaxation of monetary policy. However, this considerably reduced the possibility of channelling up to that point immobilised assets directly to the corporate sector to maintain its liquidity.
(4) Animal spirits, with the so-called (non)-confidence multiplier, defined as general euphoria prevailing in an economic upturn or general panic reigning in an economic downturn, which prevent economic entities from behaving rationally.
The Consumer Confidence Index, which is an indicator of current conditions in this area, decreased by more than 25 points during 2008 and the first quarter of 2009, hitting its lowest level since mid-1999.
(5) These predominantly domestic factors were no sooner than in late 2008 accompanied by a major external shock — a drop in export demand, with its negative effect augmented by a very restricted possibility of substituting export demand by domestic demand and insufficient capability of substituting import demand by domestic supply. This shock has markedly exacerbated the problem of the essential structural maladjustment of the Croatian economy — the trade in goods deficit of 23% of GDP. A very vulnerable sector of services and transfers will not be able to cover this deficit, if it remains at such a level, for a long period of time.
6. Therefore, in contrast with the monetary sector, which has been consolidating, the real sector is yet to encounter the biggest problems. Their main causes include a decline in aggregate demand and an increase in illiquidity, none of which has resulted primarily from monetary factors or exclusively from external factors. However, in addressing these problems, the real sector is now faced with considerable monetary and financial limitations that it has to a large extent caused itself.
The key limitation is the one related to foreign exchange, brought about by the discrepancy between the disposable foreign exchange supply and demand generated by previous operations, which cannot be rationally covered by any "monetary acrobatics", but rather requires an appropriate adjustment, deliberate or spontaneous, of the real sector itself.
The size of this adjustment is roughly determined by the following three externally generated assumptions, which are in line with the developments recorded so far in 2009. These include:
(a) an export demand contraction of about 10%;
(b) a drop in foreign investments of about 50%;
(c) external debt stagnation.
In view of this estimate of external limitations, the current account deficit should be narrowed from EUR 4.5bn in 2008 to "only" about EUR 3bn in this year (from 9.4% to, as estimated, about 6% of GDP). A prerequisite for this is a decrease of about 15% in goods and services imports, which should be the focus of the overall policy of regulating domestic demand and requires strong efforts on the part of fiscal policy.
In this context, monetary policy will be providing liquidity support to the system only up to the level which does not pose a threat to exchange rate stability and produce, in this way, an adverse effect on the overall financial system, as recently experienced by some CEE countries.
Accordingly, the banking system's net domestic assets are estimated to increase by an approximate 9%, but they will also comprise – should there be no change in the structure of placements by sectors – an increase of only 4% in corporate and household loans. At the same time, total liquid assets will rise by about 2% and money supply will reduce by over 10%.
If the initial assumptions are proven accurate, domestic aggregate consumption may be expected to drop in real terms by about 6% and GDP to decrease by about 5% in 2009. The possibility of a lower decrease will primarily depend on global developments, which, if more favourable than projected, can to a certain extent alleviate external limitations for both the financial and real sectors of the Croatian economy.
Even in such a case, however, a crucial question remains: How to perceive this crisis? Nothing will be resolved if it is to be seen merely as a "temporary halt" to positive long-term trends of economic growth and development. On the contrary, it must primarily be regarded as a dire warning of the consequences that may arise, and that have already arisen, from neglecting the issue of the sustainability of economic growth. This warning could have been even more severe had the CNB' monetary policy stance in the previous years been different. If we take this warning seriously, this crisis will also provide us with an opportunity for a fresh approach to future economic development.
7. The problems that economic policy used to face are not substantially different from those it is facing now. In the conditions of abundant supply and a low price of foreign capital, the key problem was how to restrict surging capital inflows, which, through increases in the current account deficit and external debt, generated imbalances in the national economy and made it increasingly vulnerable to external shocks. Now that these shocks have been realised owing to the global financial crisis, the problem posed is how to reduce these imbalances, whose financing is to a large extent being transferred to limited domestic sources, in the quickest and most painless way. Therefore, to use technical parlance, the problems appear to have developed from an "over-accelerated growth" to a "hard landing". Essentially, however, the problem has always been the same — how to make an adjustment between consumption and disposable income generated by domestic production and exports, i.e., how to establish a sustainable long-term economic growth. This problem requires joint efforts from all segments of economic policy and should be a matter of special concern in the interrelation between fiscal and monetary policies.
This, on the other hand, gives rise to some well-known difficulties. The government budget and the planning documents of some extrabudgetary central government institutions are either adopted or verified by the Croatian Parliament, which also adopts laws governing certain entitlements of budgetary users and their financing sources. This makes broad fiscal policy conducive to partial interests of some social groups that are, having been politically verified as "needs", transferred to the financial and monetary sectors, which are supposed to provide sufficient liquidity for their realisation. A problem arises if the financial system liquidity level falls below the level of the established "entitlements".
A solution is found either in foreign borrowing or, when access to foreign borrowing is significantly curtailed as it is currently the case, in putting pressures on the central bank's currency issue. The central bank, unable to ignore the problem, tries to provide a partial assistance to the government in financing its needs, both at the level of annual aggregates and, especially, within the intra-year bridging of the disparity between the dynamics of fiscal revenue collection and that of expenditure realisation.
However, being an independent institution with clearly defined goals, the central bank determines its currency issue activity in accordance with the conditions and requirements of the economy as a whole. As a consequence, each relative increase in government financing needs reduces, as a rule, the relative possibility of financing other sectors. While it can be relatively easily solved in a general economic expansion, during a contraction this problem can escalate to the "crowding out" of the corporate and household sectors from the loan market. This is why in the times of crisis there is always an emphasis on the responsibility of fiscal and overall public sector consumption policies for the country's overall economic conditions.
Should relevant political agents fail to perceive this, the only solution would appear to be to seek assistance from the IMF and other international financial institutions. However, there are at least two reasons why this is not an adequate solution. The first is that we would beforehand loose a relatively significant portion of foreign exchange reserves, with the result that our external operational flexibility would be limited in the long term. The second and probably more important reason is that the IMF requirements imposed on Croatia would not be essentially different from our assumptions of what needs to be done to preserve the country's external liquidity. Relying on the IMF, as a last resort, to "prescribe" the actions to be taken, instead of taking them ourselves and preventing the escalation of the problem, could hardly be regarded as an example of responsible behaviour by economic policy makers.