Lecture

The Eurozone Crisis: Lessons for Croatia

Tomislav Presečan, MSc, Vicegovernor, Croatian National Bank
Ante Čičin-Šain Lecture, Croatian National Bank, Zagreb, September 22, 2011

1. Ever since the emergence of the latest crisis Croatian citizens and citizens in many other European countries have been facing a daunting question that shakes even the basic foundations of our faith in the financial system. Our media have duly followed developments in the leading European publications, and – in my opinion – rather inflammatory titles have been in continuous supply to our general population. Will the euro (and the eurozone) survive the crisis? This question has become so entrenched in the public opinion that our leading politicians cannot resist commenting on it.

One might be inclined to ask why. After all, the kuna, the currency of Croatia since shortly after independence, has been remarkably stable ever since its introduction. The euro is not legal tender in Croatia. In fact, as a fully-fledged currency, it is younger than the kuna. In all fairness, both the euro and the kuna could be considered newcomers, relative to some other currencies.

Why then are eurozone developments and faith in the euro of such interest to the average Croatian citizen and to the Croatian public in general?

2. Most of you here today, who are of Croatian origin, or those who are familiar with our economic situation, will be tempted to smile on hearing such a question.

The fact is that Croatians tend to take pride every morning in seeing the kuna stable, but then later in the day they decide to continue keeping their savings in the euro.

The latest data show that about 80% of household savings are in foreign currency deposits. Roughly 80% of these are in the euro.

Prior to this crisis, at some point the share of foreign currency deposits in total deposits had declined to about 60%. But then, as the global crises developed, the public became nervous when looking at the stock exchange indices, the data on our ever increasing external debt and the increases in our national spreads over the German bunds. In consequence, they withdrew and/or liquidated some of their prior investments, converted the proceeds into euros and placed them in the safest place known to them – the banks.

Banks on the other hand have to extend loans in line with their deposit base while limiting their open foreign currency positions. Therefore, they have to lend either in foreign currencies or in kuna with an exchange rate indexation clause. In most cases, this has meant that citizens in Croatia have been taking bank loans directly linked to the value of the euro. Bank credits without an exchange rate clause have been fairly rare, given the structure of deposits, and especially the absence of long-term kuna resources.

3. Previously, our people trusted the mark, and upon the introduction of the common European currency, they transferred that trust to the euro. Marks, or eagles, as the general public used to call them, were perceived as the safe haven. The German currency was not subject to inflation tax, and nobody expected that it would depreciate sharply relative to other currencies.

For executing private transactions of relatively higher individual value, such as the purchase of an apartment and/or a car, people used marks.

The trust in marks as opposed to domestic currency reflected the experience acquired in the former Yugoslavia (that is the SFRY). Its economic history since the Second World War was full of examples of systemic economic tragedies in which people lost their life savings, where foreign exchange was confiscated from them in the name of higher societal interests, where inflation taxation was built into foundations of the then-existing economic system, and where economic agents adjusted their behaviour accordingly. Hence the level of "euroization" of our economy (and some other countries that are our neighbours and share a similar history to ours), which increasingly resembles the "dollarization" known from Latin America.

4. The consequences of such a structure of savings for monetary policy are fairly clear. The functioning of the central bank in such an environment is very much like a de facto currency board. However, the absence of a de jure currency board framework gives latitude to some of our politicians and to some other publicly known individuals to espouse grandiose ideas that would, they believe, if implemented, rid the country of the curse of "euroization". We will revert to these issues in a while – this is why I like lectures such as this – but let me get back to the original dilemma of the euro position today.

5. The latest crisis just served as an amplifier to all those who, since the beginning of the EMU creation, were rather sceptical about its sustainability. While Croatia has its share of such sceptics, there are many more of them on the other side of the Atlantic, or across the Channel, and there are also some in the eurozone itself. These days it seems that they have a reason to say – "we told you so, it will not work". And this very message, whether credible or not, has been transmitted over and again by multi-faceted, wide-reaching and ever-present media.

6. What seems to be the problem with the EMU architecture at present? I'm inclined to argue that the original idea and architecture were not bad. Imagine that the debt ceiling of 60% was enforced, as well as the Stability and Growth Pact. Would we see a problem that looks so difficult to solve today? Obviously, the answer would be no. Some of the eurozone countries would still be facing their own issues (not all macroeconomic problems come from lax budgetary policies!) but we would not be talking about the sustainability of the eurozone project.

7. One has to assume the founding fathers of the EMU were aware of the main risk of having one common currency for many sovereign countries. They created a fiscal rule and prohibited monetary financing of budgets to avoid precisely what we are seeing today. What happened, as we all know, is that the original architecture was gradually weakened in a number of ways by the decisions of policy makers. The circumstances in which these decisions were made and the expectations the policy makers attached to these decisions might be a topic for some thriller, but we will not try to address it today. However, we will debate the effects that these gradual alterations of the fiscal rules have had on the eurozone.

8. What can be heard from experienced EU insiders is an ever-increasing view that it was naive from the start to believe that any fiscal rule could be enforced. Many now expressing this view are doing so with the benefit of hindsight. Nevertheless, it may indeed be the case that, regardless of the benefits of hindsight, they are correct. But if that is the case, we must then say that not only was the original design flawed, but that it is extremely difficult to believe that there is a sustainable design for the euro area.

9. This is the fundamental question about the future of the monetary union of independent states, and it belongs more to the politics of the EU than to the economics side of the project.

10. Given the frequency to date of the political imperative trumping economic logic, it is reasonable to expect that it will take much more to convince the markets to believe that a second attempt to put a fiscal rule in place will be a credible one.

11. So, what would it take to achieve credibility and to be able to say that this time around it will be different? There are some people who suggest that a eurobond would do the trick (and some countries hope for it), whereas others believe that the EFSF/ESM will be enough to persuade the markets.

12. It is my belief that the solution lies in the root cause of the current problem, which is the lack of fiscal discipline. Without fiscal discipline, or some kind of the fiscal rule that can be enforced, there is no prospect of a long-term and stable monetary union. If there had been effective fiscal discipline in the first place, there would have been no need for EFSF/ESM, ECB's securities purchases or a eurobond.

13. To have a eurobond, one would still require a fiscal rule incumbent on individual countries. Otherwise the eurobond would not be credible and it could possibly endanger core countries. Also, imposing fiscal discipline indirectly tackles the other crucial question – that of structural pro-growth reforms. By restricting the fiscal stimulus, which is more often than not misused and, as we all very well know, can work only temporarily, governments will be forced to implement structural reforms to boost growth and the incomes of the electorate. Otherwise, they can only borrow, distribute and get re-elected on the basis of that – but it cannot last forever, as we have seen by looking at some of the eurozone countries.

14. So, the key question for the sustainability of the EMU architecture is how to impose fiscal discipline in a credible manner, and secondly, how to get out of the current problems without triggering the level of political upheaval that would threaten the foundations of the EMU.

15. The alternative to this – if it could be even labelled a possible alternative at all, and no true central banker will ever even think of supporting such a heresy – would be to let the markets impose fiscal discipline on individual countries as they do with individuals or corporates. However, this would be extremely disorderly and costly. As markets tend to be wrong for prolonged periods of time, they also tend to overreact at a time of crisis. It is also useful to mention that the markets themselves were poorly pricing the risks of eurozone countries, as they have now found out to everyone's cost. Still, eventually, markets tend to correct themselves. Moreover, history /has taught us that politicians left to their own devices tend to be wrong even more often and for longer periods of time than markets.

16. How can all this be put briefly as a lesson for all of us in Croatia? After all, we are not a eurozone country but merely a humble and aspiring future member of the EU. The introduction of the euro is ahead of us, but certainly not during the next year or the following one.

17. What applies to the eurozone with respect to sustainability should apply at least equally to an aspiring prospective member country, that is, to Croatia. This is where I get back to the topic of great ideas on how to get rid of euroization here. By imposing a credible fiscal rule and sticking to it, as stipulated in the recently debated and enacted Fiscal Responsibility Law, and by implementing the needed structural pro-growth reforms, we will maintain our financial stability and at the same time create conditions for economic expansion. It would exceed the time available to describe all these structural measures to you today. These topics have been debated by everybody in this country and are especially hot now, just before the general elections. However, any foreign investor in Croatia can fill you in on a number of things she and/or he thinks could be improved. Persevering in doing this, inter alia, will enable us to pass the ERM2 entry test, to fulfil the Maastricht criteria, and to introduce the euro as our legal tender at the end of this adjustment process.

18. In these future circumstances, once we enter the eurozone, all our citizens who have bank credit linked to the euro will cease to carry the ever-present exchange rate risk, and the CNB bestseller (our daily updated nominal exchange rate list) will suddenly become less popular. However, it needs to be a joint effort on the part of all of us. The euro will not solve all our problems, and it will not come as a substitute for intelligence – contrary to the expectations of many here. The current and very actual experience of people who took on bank credit linked to the Swiss franc has shown us very vividly what happens when the currency in which one earns is not the currency in which one owes and when the latter appreciates significantly in value. If such a story were to be emulated by all those who have bank credit linked to the euro it is clear that it would not help anyone in this country, although there are people who have been claiming otherwise for quite some time. Of course, nomina sunt odiosa, but the general public will be able to recognize and distinguish such policies.

19. To summarize my point here: I do believe that we will only get rid of euroization when we introduce the euro. The pattern of behaviour of our population will not be changed even if some initiatives to eliminate exchange rate indexation clauses in lending contracts are successful in our Parliament.

20. On the other hand, just as in the EU, neither electorate nor politicians can expect that the state can continue to borrow and distribute resources to interest groups. In this regard, it is the duty of any responsible politician to spell out the basic facts of economic life to the electorate and for the electorate to discern between those who do so and those who still cannot.

21. This is also the relevant thought that we need to take home from this lecture. Moreover, all of us in this country need to start behaving accordingly, which might be the most difficult part of our future.

 

The usual disclaimer applies:
the entire text of speech is author's work and does not necessarily represent the views of the Croatian National Bank.
I am grateful to Mr. Boris Vujčić, the CNB Deputy Governor, for allowing me to echo some of his recent remarks concerning the architecture of the eurozone, to Mr. Neven Mates, for all his suggestions and comments, and to Gerry Danaher and Vesna Cruickshank, for their patience and perseverance in correcting all the mistakes in English that I have ever committed.