How Emerging Europe Came Through the 2008/09 Crisis

Chapter 21. Croatia: Averting Financial Crisis but Struggling to Become Competitive

Bas Bakker, and Christoph Klingen
Published Date:
August 2012
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Croatia entered the global financial crisis with an unsustainable growth model characterized by strong domestic demand and current account deficits, financed by credit growth and capital inflows. External competitiveness was low. These underlying problems were exposed when capital flows seized with the onset of the crisis. Economic activity contracted sharply and public finances deteriorated. Strong, proactive financial sector policies and foreign parent banks’ willingness to maintain exposure helped avert a full-blown financial crisis. Nonetheless, a stable exchange rate regime, overstretched balance sheets, and long-standing rigidities make it difficult to return to positive growth.


Croatia’s economy suffered a large setback during the war of 1991–94. The war destroyed much of Croatia’s industry directly and severed critical trade linkages with the rest of the former Yugoslavia. Growth resumed in 1995, driven by large reconstruction needs and sizable government expenditure programs, such as the upgrading of the road network. During 1995–2002, real GDP growth averaged some 4 percent and the current account deficit exceeded 6 percent of GDP. Progress in liberalizing the economy was more limited than elsewhere in emerging Europe. The budget continued to support a number of large loss-making companies, notably in shipbuilding, railways, and steel. The public sector also remained large by European standards.

The Run-Up to the Global Financial Crisis

Croatia’s precrisis growth was dependent on capital inflows that financed domestic absorption. During 2003–08, private consumption and investment, mostly in the construction sector, were the main drivers of economic growth. Abundant foreign capital inflows, predominantly in the form of debt, were channeled through the foreign-owned banking system or directly provided to domestic corporates by the foreign parent banks. This fueled strong private sector credit growth. Most of the loans were denominated in, or indexed to, foreign currency (Atoyan, 2010). Credit predominantly financed activities in the nontradable sector, while the relative importance of exports declined. Trade deficits were high even by regional standards, with net exports contributing negatively to growth each year during 2003–08. On the whole, easy financing conditions allowed Croatia to continue to grow at a fast clip and run large current account deficits, resulting in a rapid buildup of external debt.

The lagging export performance reflected, among other things, underlying competiveness problems. Wages had been historically high and unit labor costs also appeared uncompetitive when compared to Croatia’s overall income level (Figure 21.1). Meanwhile, limited progress in key structural reforms saddled the economy with pervasive rigidities. Almost two decades after the beginning of transition, Croatia lags behind its European peers in large-scale privatization, enterprise restructuring, and competition policy. Strict labor regulations severely constrain labor market flexibility, while generous social benefits reduce labor force participation and burden those employed in the formal sector. The combination of relatively high wage levels and an inflexible economy meant that Croatia did not succeed in attracting substantial greenfield foreign direct investment to expand its export sector. Exports remained below their potential during the precrisis years, and Croatia continues to be a relatively closed economy.

Figure 21.1Selected European Countries: Average Gross Monthly Wages versus Per Capita GDP, 2008


Sources: Haver Analytics; and IMF staff calculations.

Macroeconomic policies had only limited success in dampening credit growth and may even have contributed to the buildup of vulnerabilities. While the headline fiscal deficit was brought down to 1¼ percent of GDP by 2008, the cyclically adjusted fiscal balance remained large during the boom years. Similarly, public debt, including the guaranteed stock, remained elevated, leaving little room for fiscal maneuver during the crisis (Rahman, 2010). Challenging reform needs in the public sector were left unaddressed, creating ossified spending structures with high mandatory expenditure. Monetary policy during the precrisis years was largely geared toward maintaining exchange rate stability. While the stable exchange rate regime kept inflation and inflation expectations low, it also reduced the perceived exchange rate risk and therefore may have contributed to excessive foreign currency borrowing, including direct cross-border borrowing by nonfinancials.

Financial sector policies were mainly concerned with ensuring the stability of the banking system in the face of large capital inflows. Since 2003, the Croatian National Bank had used a variety of measures to lean against the wind in an attempt to slow the pace of credit growth. These included conventional measures, such as higher reserve requirements and higher risk weights for unhedged foreign currency loans, as well as unconventional measures, such as ceilings on credit growth, marginal reserve requirements on foreign borrowing, and foreign currency liquidity requirements. These measures had some success in reducing credit growth, though foreign parent banks substituted capital injections for lending to Croatian subsidiaries to finance credit expansion and they increasingly resorted to extending credit directly to Croatian corporates. Nonetheless, these measures helped build up liquidity and capital buffers in the local banking sector, which proved useful during the crisis.

Croatia entered the crisis with a strong financial sector but an uncompetitive and highly vulnerable economy and with little room for policy maneuver. The many years of large current account deficits had pushed Croatia’s external debt to over 80 percent of GDP by 2008. The associated high rollover needs, together with sizable current account deficits, posed substantial external financing risks. The fiscal position was highly susceptible to any economic downturn and, with sizable structural deficits and public debt, it left little or no policy room. Meanwhile, extensive euroization in the banking system—where three-quarters of assets were denominated in foreign currency—accentuated balance sheet risks and constrained the authorities’ monetary and exchange rate policy options. Although the banking sector itself was profitable and sound, the high indebtedness of households and corporates meant that any downturn would affect banks’ asset quality.

Impact of the Global Financial Crisis

Financing conditions for Croatia deteriorated sharply in late 2008. Conditions in the financial markets, both external and domestic, worsened in the fourth quarter of 2008 as capital inflows experienced a marked slowdown, although they remained positive, and foreign bank exposure held up. Bond and CDS spreads shot up, the Zagreb stock market plunged, and pressures on the kuna exchange rate intensified.

The mere slowdown of capital inflows was enough to push the Croatian economy into a severe recession. Tight credit conditions and diminished confidence caused domestic demand to contract. With trading partners’ imports also contracting and poor competitiveness, exports plunged. After experiencing a slowdown since the second quarter of 2008, real GDP growth halted in the fourth quarter and dropped sharply by 6¾ percent year-over-year during the first half of 2009.

Policy Responses

Croatia’s initial policy actions focused on supporting financial and exchange rate stability. Given the extent of the economy’s euroization and the adverse balance sheet effects associated with any sharp depreciation, the Croatian National Bank adopted a three-pronged approach: support for the kuna, liquidity maintenance in the interbank market, and alleviation of capital outflow pressures. In addition to tightly managing kuna liquidity in the interbank market, the central bank intervened intermittently in the foreign exchange market to contain depreciation pressures. It also reduced the overall reserve requirements, relaxed regulatory requirements for repo auctions, and simplified rules for access to liquidity assistance in order to address liquidity shortages in the interbank market. To counter capital outflow pressures, the Croatian National Bank eliminated the marginal reserve requirement on banks’ foreign borrowing, quadrupled the insurance coverage of deposits, and impressed upon the banks the need to keep their profits in Croatia. The commitment of foreign parent banks to maintain their share in the market also shielded the Croatian subsidiaries.

Considering the large financing needs and the uncertain market outlook, fiscal policy focused on containing the budget deficit. As economic activity dropped sharply in the first quarter of 2009, Croatia faced a difficult trade-off between supporting growth by allowing the fiscal deficit to widen, on the one hand, and keeping public financing needs at a manageable level, on the other. The rapid deterioration in revenues, particularly from indirect taxes, and the lack of fiscal space made it difficult to implement any fiscal stimulus to support growth. In the course of 2009, the authorities adopted three supplementary budgets to contain the overall deficit. The measures in these budgets, amounting to 2¼ percent of GDP, were mostly on the spending side. They included cuts in discretionary expenditure, wage and pension freezes, a value-added tax rate increase, and the introduction of a temporary surtax on high incomes and pensions. These measures contained the 2009 fiscal deficit to some 4 percent of GDP.

This policy mix succeeded in improving market sentiment. As 2009 progressed, the kuna recouped its losses, official reserves were rebuilt, and bond spreads came down considerably. Liquidity pressures in the banking system eased, with parent banks maintaining credit lines to their domestic subsidiaries and domestic deposits stabilizing. Although credit quality worsened significantly and profitability declined during 2009, the banking sector came out of the crisis still well capitalized. The Croatian government was also able to tap international capital markets twice in 2009.

In 2010, following others in the region, Croatia put in place credit support schemes to spur growth. With tight credit conditions amid risk-averse banks and a reluctant, highly leveraged private sector, Croatia introduced multiple credit schemes to stimulate bank lending. In the context of low inflationary pressures and a sizable output gap, these schemes, whose combined size was less than 3 percent of GDP, were thought to provide a needed boost. The schemes released liquidity through a conditional reduction in reserve requirements to boost credit for both working capital and new investment, with the government providing guarantees for the latter. But while credit recovered somewhat, growth did not pick up.

Economic Outcomes in 2009–11

The policy response was successful in staving off financial meltdown, but a protracted recession could not be avoided. Economic activity contracted by 6 percent in 2009—a rate close to the regional average. The current account deficit also improved substantially, as imports fell in the wake of weak domestic demand. However, Croatia was one of the few countries in the region still mired in recession in 2010, and the only one failing to post positive growth in 2011. The credit schemes, which were slow to take off, had a limited impact in restoring credit growth, particularly for new investment, as uncertainties lingered and demand for credit remained feeble. Compromised competitiveness is still very much an issue and stands in the way of shifting to a new growth model that relies more on a vibrant tradable sector.

Challenges Ahead

Croatia’s key challenge is to achieve durable growth. Croatia’s growth has relied on domestic demand, foreign financing, and the nontradable sector for many years. With new foreign financing now in short supply and indebtedness already at high levels, Croatia needs to change track. Going forward, growth will have to come more from the tradable sector. This in turn requires addressing Croatia’s external competitiveness problems, which are manifested in large and persistent trade deficits, and a relatively narrow and undiversified export base. While the underlying reasons are complex, there are some obvious deficiencies. Wages are set rigidly, and nominal wages appear too high relative to most of Croatia’s peers, particularly in the skill-intensive manufacturing subsectors. A poorly rated business environment compared to regional peers points to room for improvement on the structural front.

Improving price competitiveness involves difficult policy choices. The high degree of financial euroization and a large external debt burden reinforce the authorities’ preference for sticking with the stable exchange rate regime. Competitiveness gains would then need to come from reducing income and wages to bring them down to more competitive levels. There would be a cost in terms of foregone growth during the adjustment period.

Structural reform should also be brought into play to help improve growth prospects. According to the World Bank (2009), Croatia’s largest growth dividend could come from increased labor force participation. With population projected to decline at an accelerated pace through 2050, increasing labor force participation needs to be achieved by changing the social benefits parameters so as to strengthen incentives to work and by making labor contracts more flexible so as to facilitate hiring. Croatia also needs to improve its business environment through a reduction of the regulatory burden and completion of pending privatization. Recent reforms to harmonize the retirement age between men and women, increase the penalty for early retirement, introduce incentives to delay retirement, and reduce the duration and amount of unemployment benefits constitute notable progress. However, challenging reforms to allow for more flexible wage setting and to reduce the size of the public sector are yet to be tackled.

In addition, Croatia will also need to increase its fiscal policy space. As a small open economy, Croatia is highly susceptible to external shocks. Under its stable exchange rate policy, fiscal policy becomes the main demand management tool. But fiscal policy can only fill this role once consolidation has generated sufficient room to maneuver. This would require implementing strong fiscal consolidation to balance the overall budget over the medium term and lower public debt to safer levels. That in turn would facilitate maintaining a cyclically adjusted balanced fiscal position over the long term.

Recognizing these challenges, the government adopted a comprehensive reform package in the first half of 2011, known as the Economic Recovery Program. The goal of this 10-year plan, which includes 131 measures in 10 key areas, is to generate economic recovery in the short term and create a more competitive economy in the longer term. As such, it aims to ensure fiscal sustainability through a reduction in pension and health expenditures, better targeting of social spending, and implementation of a Fiscal Responsibility Law. It intends to reduce government interference in economic activities through privatization, civil service retrenchment, and better management of public enterprises. It also includes complementary reforms in the labor market, education, and the judiciary to strengthen the role of the private sector. Although initially greeted with strong enthusiasm, the program faces implementation challenges. Progress has been made in reducing unemployment benefits, adjusting pension parameters, and reducing health expenditures. However, advancing the macro-critical reforms, such as privatization, public administration reform, and labor market flexibility, will be up to the new government, which took office in December 2011.

Croatia: Principal Economic and Financial Indicators, 2003–11
Real Sector Indicators
GDP (real growth in percent)−6.0−1.20.0
Domestic demand (real growth in percent)−9.0−3.8−0.4
Net exports (real growth contribution in percent)−1.2−0.2−0.5−1.6−1.5−
Exports of goods and services (real growth in percent)−
CPI (end-of-period change in percent)
Employment (growth in percent)−2.0−4.5−3.3
Unemployment rate (percent)14.313.812.711.
Public Finances
Fiscal balance (percent of GDP)−4.7−3.4−2.8−2.6−2.1−1.3−4.1−4.9−5.5
Government revenue (percent of GDP)
Government expenditure (percent of GDP)43.842.441.441.241.940.442.341.941.4
Government primary expenditure (percent of GDP)42.140.639.539.340.238.940.639.939.0
Government primary expenditure (real growth in percent)−1.1−1.9−2.8−2.4
Public debt (percent of GDP)35.437.638.235.432.929.
Of which foreign held21.821.716.215.714.99.612.613.4
External Sector
Current account balance (percent of GDP)−6.0−4.1−5.3−6.7−7.3−8.9−5.0−1.00.9
Net capital inflows (percent of GDP)113.87.610.813.711.711.
Other investment5.
Exports (percent of GDP)43.443.142.442.742.141.535.738.639.3
Exports (€, growth in percent)−
Global export market share (basis points)
Remittances (percent of GDP)
Imports (percent of GDP)50.048.948.349.249.349.539.138.637.3
Imports (€, growth in percent)−24.2−0.6−3.2
External debt (percent of GDP)73.476.368.678.582.482.0102.7102.193.8
Gross international reserves (€ billions)
Gross international reserves (percent of GDP)24.021.419.623.023.018.523.524.724.4
Reserve coverage (GIR in percent of short-term debt)159.5119.480.686.6112.770.399.567.272.2
Monetary Sector
Broad money (end of period, growth in percent)11.08.610.518.018.34.3−
Monetary base (end of period, growth in percent)23.919.920.616.75.2−12.75.9−0.311.3
Private sector credit (end of period, percent of GDP)45.748.552.659.262.364.465.970.172.2
Of which foreign currency denominated3.
Of which foreign currency indexed38.835.138.743.346.7
Cross-border loans to nonbanks (Q4, percent of GDP)13.814.221.025.934.233.937.234.128.4
Private sector credit (end of period, real growth in percent)13.211.512.720.48.89.0−
Financial Sector
Assets (percent of GDP)87.591.896.4103.6106.5105.6111.7117.7121.1
ROA (percent)
ROE (percent)
CAR (percent of risk-weighted assets)16.516.
NPLs (percent of total loans)
Loan-to-deposit ratio0.
Cross-border claims by foreign banks (all sectors, percent of GDP)33.533.344.656.971.862.371.265.259.3
Financial Markets
Interest rates (end of period, one-year government bond, percent)
CDS spreads (sovereign, end of period, basis points)10235382066443236258547
EMBIG spread (sovereign, end of period, basis points)195298663
Exchange rate (end of period, domestic currency/€)
NEER (index, 2003 = 100)100.0102.2102.8104.1104.7107.4106.7105.1103.6
REER (CPI-based, 2003 = 100)100.0101.9103.4105.6106.3111.2112.3109.6107.2
REER (ULC-based, 2003 = 100)
Memorandum Items
GDP (nominal, in billions of domestic currency)229247267291318345335335341
GDP (nominal, in billions of €)
Source: IMF staff.Note: CAR = capital adequacy ratio; CDS = credit default swap; CPI = consumer price index; EMBIG = Emerging Markets Bond Index Global; FDI = foreign direct investment; GIR = gross international reserves; NEER = nominal effective exchange rate; NPLs = nonperforming loans; REER = real effective exchange rate; ROA = return on assets; ROE = return on equity; ULC = unit labor cost.

Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.

Source: IMF staff.Note: CAR = capital adequacy ratio; CDS = credit default swap; CPI = consumer price index; EMBIG = Emerging Markets Bond Index Global; FDI = foreign direct investment; GIR = gross international reserves; NEER = nominal effective exchange rate; NPLs = nonperforming loans; REER = real effective exchange rate; ROA = return on assets; ROE = return on equity; ULC = unit labor cost.

Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.

The main authors of this chapter are Jesmin Rahman and Zuzana Murgasova.

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