Abstract
The development of the Croatian financial sector has faced many of the difficulties experienced by other transition countries. Recent troubles have exacted a significant macroeconomic price but the strategy implemented by the Croatian National Bank (CNB) since the approval of the new banking law promises the early resolution of the more immediate problems. GDP at constant prices, trends in total labor costs, price developments, retail inflation rates, agricultural production, consolidated central government fiscal accounts, government employment, health insurance, disability and retirement insurance, and so on are presented in detail.
III. External Vulnerability Analysis 1
A. Introduction
72. Croatia’s macroeconomic performance in the mid-1990s surpassed that of many other regional economies. During 1993–97, growth was robust, inflation remained subdued, the government deficit was contained, and the ratios of external debt to GDP and debt service to exports remained well below the average of other transition economies in Central and Eastern Europe. More recently, however, large current account deficits and the shift of their financing from nondebt creating flows to external borrowing have led to a sharp increase in the external debt ratios. In particular, the external debt to GDP ratio doubled between end-1995 and mid-1999.
73. This chapter attempts to assess the vulnerability of the Croatian economy to balance of payments and financial crisis. It looks in particular at a range of indicators on which attention has increasingly focused for emerging market economies since the Asian financial crisis, comparing the Croatian economy with comparable transition countries in Central and Eastern Europe. In addition, some indicators of market perception are also presented.
B. External Vulnerability Indicators
74. With the series of major economic shocks that have affected emerging market economies over the last five years, including the “tequila” crisis of late 1994, the Asian crisis that began in 1997, and the Russia crisis in 1998, attention has increasingly focused on how to assess the risk of liquidity crisis in these economies. Several studies looked at the extent to which the depth and incidence of crises reflect solvency related fundamentals, and whether and to what extent they reflect a lack of liquidity.2 These studies tried to establish the relevance of key variables in providing early indications of currency crises.
75. Indicators that appeared to be particularly useful in that context include the current account deficit, export growth, the deviation of the real exchange rate from trend, the ratios of short-term debt and broad money to gross international reserves, and the change in reserves. The first three (current account deficit, export growth and deviations of the real exchange rate) are indicators of solvency: low current account deficits lead to lower needs for external borrowing, high export growth ensures that future debt service as a percent of external revenue is smaller for a given current account deficit, and changes in real exchange rates affect the future path of the current account deficit. The other three are liquidity indicators: the ratio of short-term debt (on a remaining maturity basis) to reserves indicates the ability of a country to service its debt falling due over the coming year if the country is cut off from external financing, the ratio of broad money to reserves captures the potential for capital flight by residents, while the change in reserves is an indicator of the residual influences on the balance of payments.
76. IMF staff has developed an Early Warning System based on such a set of indicators meant to allow for a long-range alert of the external vulnerability of countries. Particular efforts have also been made to improve the analysis of liquidity issues per se, and in particular of the adequacy of international reserves. The traditional measure comparing reserves to imports does not provide an indication of the ability of reserves to buffer against capital market shocks. Thus, attention has shifted to the ratio of reserves to short-term debt, where short-term debt is defined on a remaining maturity basis. Empirical work suggests that this ratio is indeed a reasonably good predictor of the incidence and depth of crises, even if no single measure can capture all dimensions of vulnerability.
77. Attempts have been made to find simple benchmarks that a country should satisfy in order to minimize vulnerability. An appealing benchmark of “one” for the ratio of reserves to economy-wide short-term debt has received some empirical support. Bussière and Mulder (1999), for instance, found that a ratio of at least one, even with a modest current account deficit and a slightly appreciated exchange rate, would ensure that the risk of a crisis remains low. As another benchmark, it has been suggested that countries should manage their external assets and liabilities in such a way as to be able to live without foreign borrowing for up to one year. This so-called Guidotti rule would require countries to hold reserves not only to cover liabilities maturing within a year, but in addition reserves sufficient to cover one year’s current account deficit. A modified Guidotti rule, which has also received attention, consists of adding net FDI to the current account deficit.
78. In looking at measures of liquidity, an important issue is the exact definition of the concepts of reserves and short-term debt. In particular, all forward liabilities should be recognized as such, and debt with embedded put options should be taken to be payable on the earliest date when the creditor can demand repayment. Also, any part of the reserves pledged or used as collateral should be excluded from the concept of usable reserves, as such reserves prove not to be readily available in time of financial crisis.
C. External Vulnerability of Croatia
79. In the mid-1990s, following a successful stabilization program initiated at end-1993, the external position of the Croatian economy looked fairly robust (Table 14): the current account balance averaged a surplus of 1.2 percent of GDP in 1993–95; the real exchange rate had stabilized; the ratio of external debt, mostly inherited from the former Socialist Federal Republic of Yugoslavia (SFRY), to GDP was very low at about 20 percent, the international reserves position was relatively comfortable, with a ratio of short-term debt (on a remaining maturity basis) to official gross reserves of about one third in 1995 and net international reserves equivalent to more than 2 months of imports of goods and non-factor services. Only the very modest growth in exports and a strong expansion of bank credit to the private sector during the three preceding years suggested some caution.
Croatia: Selected External Vulnerability Indicators, 1995-98
(In percent, unless otherwise indicated)
Short-term debt is on a remaining maturity basis.
Croatia: Selected External Vulnerability Indicators, 1995-98
(In percent, unless otherwise indicated)
| 1995 | 1996 | 1997 | 1998 | |
|---|---|---|---|---|
| Real Effective Exchange Rate Appreciation (cumulative over last 4 years) | … | 40.3 | -0.1 | 1.6 |
| Total External Debt to GDP Ratio (year end) | 20.8 | 23.2 | 31.9 | 37.1 |
| Short-Term Debt to GDP Ratio (year end) 1/ | 3.2 | 4.7 | 5.8 | 4.9 |
| Short-Term Debt to Reserves Ratio (year end) 1/ | 31.6 | 40.7 | 45.6 | 37.8 |
| Short-Term Debt and Current Account Net of FDI to Reserves Ratio (year end)l/ | 102.8 | 67.2 | 118.7 | 61.5 |
| Broad Money to Reserves Ratio (in units) | 2.4 | 2.8 | 3.1 | 3.2 |
| External Reserves in Months of Imports of Goods and Non-Factor Services | 2.4 | 2.8 | 2.7 | 3.2 |
| Current Account Balance to GDP Ratio (3-year average) | 1.2 | -2.6 | -8.4 | -8.2 |
| Banking Sector Credit to Private Sector (3-year change in percent of GDP) | 43.1 | 13.3 | 18.9 | 21.1 |
| Growth in Exports of Goods and Nonfactor Services (3-year average) | 0.6 | 8.2 | 4.9 | 6.6 |
Short-term debt is on a remaining maturity basis.
Croatia: Selected External Vulnerability Indicators, 1995-98
(In percent, unless otherwise indicated)
| 1995 | 1996 | 1997 | 1998 | |
|---|---|---|---|---|
| Real Effective Exchange Rate Appreciation (cumulative over last 4 years) | … | 40.3 | -0.1 | 1.6 |
| Total External Debt to GDP Ratio (year end) | 20.8 | 23.2 | 31.9 | 37.1 |
| Short-Term Debt to GDP Ratio (year end) 1/ | 3.2 | 4.7 | 5.8 | 4.9 |
| Short-Term Debt to Reserves Ratio (year end) 1/ | 31.6 | 40.7 | 45.6 | 37.8 |
| Short-Term Debt and Current Account Net of FDI to Reserves Ratio (year end)l/ | 102.8 | 67.2 | 118.7 | 61.5 |
| Broad Money to Reserves Ratio (in units) | 2.4 | 2.8 | 3.1 | 3.2 |
| External Reserves in Months of Imports of Goods and Non-Factor Services | 2.4 | 2.8 | 2.7 | 3.2 |
| Current Account Balance to GDP Ratio (3-year average) | 1.2 | -2.6 | -8.4 | -8.2 |
| Banking Sector Credit to Private Sector (3-year change in percent of GDP) | 43.1 | 13.3 | 18.9 | 21.1 |
| Growth in Exports of Goods and Nonfactor Services (3-year average) | 0.6 | 8.2 | 4.9 | 6.6 |
Short-term debt is on a remaining maturity basis.
80. In 1995–96, Croatia made rapid progress in normalizing its external relations by concluding debt rescheduling agreements with the Paris Club and the London Club. Reflecting Croatia’s sound debt and reserve positions, and favorable external prospects, three credit agencies awarded Croatia an investment grade sovereign credit rating in early 1997, putting Croatia among other transition economies such as Poland and Hungary.3 This allowed Croatia to rapidly gain access to capital markets, and shift away from short-term inflows to medium- and long-term borrowing. In particular, Croatia issued three eurobonds of US$300 million, DM 300 million and ATS 700 million, respectively, in 1997, and one eurobond (so-called “Matador” bond) of Ptas 15 billion in 1998 4
81. Much larger current account deficits in 1997 and 1998, reaching the equivalent of 11.6 percent and 7.1 percent of GDP, respectively, were largely financed through new external borrowing, thanks to the newly gained access to capital markets. This contributed to a substantial increase in the stock of external debt, which reached the equivalent of about 37 percent of GDP at end-1998, out of which public and publicly guaranteed debt was equivalent to about 20 percent of GDP.5 Thus, at end-1998, several indicators of solvency were showing signs of growing weakness: the current account deficit averaged 8.2 percent during the three preceding years; the external debt to GDP ratio nearly doubled—albeit from a low base—in 3 years; and the growth in exports remained very modest.
82. Regarding the indicators of liquidity position, net international reserves increased by about US$900 million between end-1995 and end-1998, to reach the equivalent of 2.9 months of imports of goods and nonfactor services. While the stock of short-term debt (on a remaining maturity basis) increased somewhat during 1995–98, its ratio to gross reserves was still relatively low at about 37 percent at end-1998. The indicator based on the modified Guidotti rule, namely the ratio of short-term debt corrected for the current account deficit net of foreign direct investment to reserves, was less favorable at about 62 percent at end-1998, after decreasing from a peak of about 119 percent at end-1997. Finally, the ratio of broad money to reserves increased steadily between end-1995 and end-1998 from 2.4 to 3.2, with about two-thirds of broad money in the form of foreign currency deposits. This seemingly still comfortable, albeit weakening, external liquidity position should be seen, however, against the fact that part of the increase in official reserves reflected an increasing stock of foreign currency liabilities of the monetary authorities to residents. With the implementation of new regulations regarding reserve requirements on foreign currency deposits in the third quarter of 1998, domestic commercial banks began to accumulate reserve deposits in foreign exchange with the central bank from September 1998 through April 1999. The central bank also started issuing bills in foreign exchange in April 1998. The stock of these central bank foreign exchange liabilities amounted to about US$500 million at end-1998 and US$740 million in mid-1999.
83. A important worry from the standpoint of vulnerability in the last few years has been the emerging weakness in the banking sector. In 1998, a weak economy and a drying-up of repatriated foreign savings exposed the underlying insolvency of a rapidly growing group of private banks. The central bank had to intervene in an increasing number of banks, and public concerns about the soundness of the banking sector contributed to exchange market pressures in late 1998 and early 1999. At the same time, Croatian banks switched from a significant short position in foreign exchange at end-1997 to a long position by the third quarter of 1999. While it improved banks’ direct exposure to currency depreciation, it also added to the pressures on the exchange rate during this period. Banks’ indirect exposure to currency depreciation, however, likely remains substantial, given that an estimated 50 to 60 percent of banks’ domestic assets are denominated in, or indexed to, foreign currency, of which a substantial proportion may be presumed to be uncovered by the borrowers.6
84. Comparing external vulnerability indicators for Croatia with those for other Central European economies confirms the view that, while the external liquidity position of Croatia still remains favorable, Croatia’s position in terms of external solvency indicators is weaker. External vulnerability indicators at end-1998 were compiled for a sample of 10 other Central and Eastern European countries (see Figure 9).7 The ratios for Croatia of short-term debt and short-term debt corrected for the current account deficit net of FDI to reserves are in the median to lower range of the sample. The more traditional measure of reserves in months of imports shows Croatia’s position at the average of the sample. Croatia is also one of the few countries in the sample, together with the Slovak Republic and Slovenia, not to have had an appreciation of its real exchange rate over the last four years.8 However, Croatia compares less favorably regarding the current account, growth in exports, stock of external debt and growth in banking sector credit to the private sector indicators, although it is never among the worst ranked countries of the sample.
Croatia: External Vulnerability Indicators in a Regional Perspective 1/ Liquidity Indicators
Citation: IMF Staff Country Reports 2000, 022; 10.5089/9781451817300.002.A003
Sources: WEO database; and International Financial Statistics.1/ In each chart, the average of the sample is represented by a line.2/ Short-term debt is on a remainig maturity basis.(continued). Croatia: External Vulnerability Indicators in a Regional Perspective 1/ Solvency Indicators
Citation: IMF Staff Country Reports 2000, 022; 10.5089/9781451817300.002.A003
Sources: WEO database; and International Financial Statistics.1/ In each chart, the average of the sample is represented by a line.2/ Short-term debt is on a remaining maturity basis.(concluded) Croatia: External Vulnerability Indicators in a Regional Perspective 1/ Solvency and Other Indicators
Citation: IMF Staff Country Reports 2000, 022; 10.5089/9781451817300.002.A003
Sources: WEO database; International Financial Statistics; and Information Notice System.1/ In each chart, the average of the sample is represented by a line.D. Financial Markets’ Perception
85. In the last few years, financial market participants have viewed Croatia with some concern. Following the Asian financial crisis, interest spreads on Croatia’s foreign bonds increased by more than in other transition countries with a similar investment-grade credit rating. After initially trading at less than 100 basis points during the first half of 1997, the spread on Croatia’s eurodollar bond, which was issued in February 1997 and will mature in 2002, reached about 300 basis points in January 1998 (Figure 10). In the wake of the Russian crisis, the spread increased markedly, reaching more than 600 basis points in October 1998. Since then, it has fluctuated within a range of 360–530 basis points, which is comparable to bonds in lower investment grade rating categories. Countries with similar credit rating to Croatia, such as Malaysia, South Korea or Thailand, currently carry yields that are about 350 basis points below that on Croatian bonds.
Croatia: Financial Markets Indicators, 1997-99
Citation: IMF Staff Country Reports 2000, 022; 10.5089/9781451817300.002.A003
Sources: Bloomberg; and Zagreb Stock Exchange.86. During 1999, three credit-rating agencies issued negative reviews. In April, Croatia lost its investment grade rating from IBCA. This was attributed to the increased fiscal deficit and heightened pressures on the current account and banks, in the context of a halt to economic growth and general regional uncertainty surrounding the Kosovo crisis. In June, Standard & Poor’s and Moody’s both switched from a stable outlook to a negative outlook on foreign currency debt, which was, however, reaffirmed at investment grade ratings. Standard & Poor’s attributed the negative outlook to the increasingly uncertain domestic political environment, and severe adjustment problems in the banking and corporate sectors, in the context of tight monetary conditions and subdued economic activity. Moody’s cited large upcoming amortization payments and a lack of competitiveness as chief sources of concern.
87. The negative reviews prompted many investment firms to switch to an “underweight” recommendation to their clients, generally citing a fear of increased fiscal and current account pressures in the year 2000, an uncertain domestic political climate, and anticipation of a possible future ratings’ downgrade. On the other hand, some firms have seen the high yields on Croatian debt as offering a good investment opportunity.
88. Despite this relatively negative current perception, Croatia was able to issue its first samurai bond of ¥25 billion (about US$250 million) in early December 1999. The amount was raised from ¥20 billion initially due to strong investor demand, mainly from small- to medium-sized banks and corporations in the Tokyo area. This bond received an investment grade rating of BBB- from Standard & Poor’s, and carries a coupon of 4 percent.
89. Developments in the Zagreb stock exchange also reflected the concerns of financial market participants. The CROBEX index first fell by about 20 percent in October 1997 following the Asian financial crisis (see Figure 10). It then fell by about 50 percent between April and September 1998, following the Russian crisis, reaching an historic low on September 1, 1998, before recovering somewhat in late 1998 and early 1999. Again reflecting concerns regarding the situation of the banking and corporate sectors, as well as the uncertain political climate, the index fell by about 30 percent between mid-July and end-September 1999. Overall, the Zagreb Stock exchange index lost more than half of its value between August 1997 and end-September 1999.
E. Conclusions and Prospects
90. The external position of Croatia, which looked robust in the mid-1990s, has weakened in the last few years. In particular, several indicators of external solvency, including the current account deficit, the external debt to GDP ratio, and export growth, have shown signs of relative weakness, and do not compare favorably with some other Central and Eastern European countries. Croatia has been able, however, to maintain a comfortable external liquidity position, with international reserves more than covering the external short-term debt on a remaining maturity basis.
91. In a medium-term scenario prepared by the IMF staff, which is underpinned by a reinvigorating of structural reforms in the enterprise sector, a downsizing of the role of the government in the economy, and increased cooperation between Croatia and its trading partners, the current account deficit is expected to gradually decrease to about 3½ percent of GDP within 5 years, while net international reserves would be boosted to the equivalent of nearly 4 months of imports and the external debt to GDP ratio reduced to 33 percent (see Table below). Croatia would thus improve its external sustainability. However, reflecting large external debt repayments falling due in 2000–01, partly linked to bullet repayments of international bonds, the short-term debt to reserves ratios would worsen in the next two years before improving again thereafter. Gross usable reserves are nevertheless projected to fully cover the external short-term debt on a remaining maturity basis over the 5-year projection horizon.
Croatia: Medium-Term Scenario
(In percent of GDP, unless otherwise indicated)
In months of imports of goods and nonfactor services
Short-term debt is on a remaining maturity basis.
Croatia: Medium-Term Scenario
(In percent of GDP, unless otherwise indicated)
| 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | ||
|---|---|---|---|---|---|---|---|
| Current account balance | -6.5 | -5.0 | -4.5 | -4.0 | -3.8 | -3.6 | |
| Net exports of goods and nonfactor services | -8.2 | -7.2 | -6.0 | -5.5 | -4.8 | -4.1 | |
| External debt | 39.0 | 36.5 | 35.2 | 33.9 | 33.8 | 33.1 | |
| Net international reserves 1/ | 3.1 | 3.2 | 3.2 | 3.2 | 3.5 | 3.8 | |
| Short-term debt in percent of gross usable reserves 2/ | 88.1 | 85.0 | 94.1 | 74.0 | 64.5 | 49.2 | |
| Current account deficit and short-term debt net of FDI in percent of gross usable reserves 2/ | 83.4 | 91.7 | 100.3 | 82.1 | 70.4 | 54.5 | |
In months of imports of goods and nonfactor services
Short-term debt is on a remaining maturity basis.
Croatia: Medium-Term Scenario
(In percent of GDP, unless otherwise indicated)
| 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | ||
|---|---|---|---|---|---|---|---|
| Current account balance | -6.5 | -5.0 | -4.5 | -4.0 | -3.8 | -3.6 | |
| Net exports of goods and nonfactor services | -8.2 | -7.2 | -6.0 | -5.5 | -4.8 | -4.1 | |
| External debt | 39.0 | 36.5 | 35.2 | 33.9 | 33.8 | 33.1 | |
| Net international reserves 1/ | 3.1 | 3.2 | 3.2 | 3.2 | 3.5 | 3.8 | |
| Short-term debt in percent of gross usable reserves 2/ | 88.1 | 85.0 | 94.1 | 74.0 | 64.5 | 49.2 | |
| Current account deficit and short-term debt net of FDI in percent of gross usable reserves 2/ | 83.4 | 91.7 | 100.3 | 82.1 | 70.4 | 54.5 | |
In months of imports of goods and nonfactor services
Short-term debt is on a remaining maturity basis.
References
Bussière, Matthieu and Christian Mulder, 1999, “External Vulnerability in Emerging Market Economies: How High Liquidity Can Offset Weak Fundamentals and the Effect of Contagion”, IMF Working Paper WP/99/88 (Washington: International Monetary Fund).
Frankel, Jeffrey A. and Andrew K. Rose, 1996, “Currency Crashes in Emerging Markets: an Empirical Treatment”, Journal of International Economics, Vol. 41, pp.351-366.
Kaminsky, Graciela, Saul Lizondo and Carmen Reinhart, 1997, “Leading Indicators of Currency Crises”, IMF Staff Papers, Vol. 45, No. 1.
Sachs, Jeffrey, Aaron Tornell and Andres Velasco, 1996, “Financial Crises in Emerging Markets: The Lessons from 1995”, Brookings Papers on Economic Activity: I, Brookings Institution, pp.147-215.
Prepared by Joël Toujas-Bernaté. This chapter has benefited from inputs provided by Gary O’Callaghan.
Such studies include Sachs, Tornell and Velasco (1996), Frankel and Rose (1996), Kaminsky, Lizondo and Reinhart (1998), and Bussière and Mulder (1999).
Moody’s, Standard & Poor’s, and IBCA gave Croatia in January 1997 their lowest investment grade rating for long-term foreign currency bonds and higher ratings for short- term bonds (both in foreign currency and kuna). Uncertainties about the political process and the possible fiscal implications of restructuring demands were cited among the main reservations.
The Euro-dollar bond has a 5-year maturity and a 7 percent coupon (80 basis point over 5-year U.S. treasury bills at the time of issuance); the Euro-DM bond has a 7-year maturity and a 6.125 percent coupon (95 basis points over the German government benchmark bond at the time of issuance); the Euro-ATS bond has a 5-year maturity and a 5.625 percent coupon; and the “Matador” bond has a 3-year maturity and a 6.5 percent coupon.
At end-1998, external government debt was estimated to be equivalent to about 15 percent of GDP, and publicly guaranteed external debt to about 5 percent of GDP.
See Chapter II for a detailed discussion of recent developments in the banking sector.
The sample includes Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia.
The appreciation of the real exchange rate over the last four years for some other countries reached 40 to 80 percent. See also Chapter IV.
