Republic of Croatia: Selected Issues and Statistical Appendix
Author:
International Monetary Fund
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Publication Date:
12 Aug 2002
eISBN:
9781451817355
Language:
English
Keywords:
ISCR; CR; Croatia; export; country; expenditure; transmission mechanism; full-fledged inflation targeting; success of inflation targeting; monthly CPI; frameworks of Croatia; Emerging and frontier financial markets; Open market operations; Inflation; Exchange rates; adoption of inflation targeting
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This Selected Issues paper and Statistical Appendix examines the revenue and expenditure trends of the Croatia from a cross-country perspective and illustrates the medium-term fiscal outlook under two scenarios: one assumes gradual fiscal adjustment and structural reforms; the other assumes stronger fiscal adjustment and a more aggressive approach to structural reforms. The paper analyzes Croatia’s revenue structure to provide a perspective for the medium-term revenue policy. It also identifies the expenditure items that could be streamlined over the medium term, and presents alternative medium-term fiscal frameworks.

Abstract

This Selected Issues paper and Statistical Appendix examines the revenue and expenditure trends of the Croatia from a cross-country perspective and illustrates the medium-term fiscal outlook under two scenarios: one assumes gradual fiscal adjustment and structural reforms; the other assumes stronger fiscal adjustment and a more aggressive approach to structural reforms. The paper analyzes Croatia’s revenue structure to provide a perspective for the medium-term revenue policy. It also identifies the expenditure items that could be streamlined over the medium term, and presents alternative medium-term fiscal frameworks.

II. Practical Issues In Adopting Inflation Targeting In Croatia1

A. Introduction

1. The current framework based on exchange rate stability has been very successful in delivering low inflation. Amid high macroeconomic instability connected with the war in the first half of the 1990s, the Croatian National Bank (CNB) pursued a tight stabilization policy using the exchange rate as its nominal anchor.2 Hyperinflation was stopped in the mid-1990s, and since then the CNB has continued to pursue exchange rate stability, delivering low inflation throughout the period.

2. However, there are questions about the appropriateness of the framework going forward. The new CNB law reduces the emphasis on the exchange rate by clearly defining price stability as the primary objective of monetary policy. This objective may at times conflict with exchange rate stability as the size of international capital flows is large relative to domestic markets. Under these circumstances, sterilization may be difficult and foreign exchange interventions—needed to maintain exchange rate stability—are reflected in fluctuations in the monetary base, and, ultimately, inflation. Indeed, evidence shows that the tolerance of the CNB for exchange rate movements is very low while the volatility of international reserves, the monetary base, and inflation is large relatively to other countries with similar exchange rate arrangements.3 In the context of an IMF program, this volatility may jeopardize the attainment of quantitative targets for international reserves and base money.

3. The liberalization of the capital account, required as part of EU accession, is already testing the framework. After the prohibition to hold foreign currency accounts was lifted for businesses in June 2001, large companies moved to take open positions in anticipation of the usual seasonal pattern of the kuna. The CNB intervened frequently and in large amounts to stop early appreciation and depreciation pressures. The latter, started in August when the tourist season was peaking, subsided only in September, when the CNB introduced the obligation for banks to hold part of their foreign currency reserve requirements in kuna. The liberalization of the capital account will have to be completed fours years after the ratification of the Stabilization and Association with the European Union, which is expected to be concluded in 2003.

4. With EU accession and euro adoption still a medium-term prospect, inflation targeting is one of the alternatives being considered. As both the European Union and the European Central Bank are currently opposed to the early adoption of the euro, Croatia must consider alternatives to the current framework for the transition period. With the progressive opening of the capital account, inflation targeting would offer several advantages. First and foremost, it would provide a nominal anchor while the exchange rate would be allowed more flexibility in response to international capital flows. Second, it would help shift the focus away from short-term interventionist policies towards the medium-term goal of low and stable inflation, which is the best contribution monetary policy can make to macroeconomic stability and growth. Third, its forward-looking character would strengthen the scope and the quality of policy response to short-run developments. Fourth, it would improve discipline and accountability in monetary policy as well as fiscal policy. Furthermore, additional exchange rate flexibility would help reduce the perception of low exchange rate risk, stimulate hedging, and discourage speculative capital flows. However, these advantages would have to be weighed against the risks of excessive exchange rate volatility, which might have momentous consequences in a highly euroized economy like Croatia.

B. Main Issues

5. In general, there are no special preconditions for the success of inflation targeting. The notion that certain prerequisites should be satisfied before the introduction of inflation targeting has increasingly been contradicted by the success of this framework in many emerging countries.4 Most of these so-called “preconditions” are in fact necessary for any monetary policy strategy to be successful and in some cases have been adopted only after the introduction of inflation targeting. However, by increasing transparency and accountability, inflation targeting is more demanding than other regimes and may require to strengthen the overall policy framework. The introduction of inflation targeting is more likely to be successful if supported by a set of initial conditions, like a strong institutional framework, stable macroeconomic conditions, a well developed and stable financial system, and effective policy instruments.5

The institutional framework

6. Independent monetary policy is supported by a strong institutional framework. With the new CNB law, approved by parliament in 2001, Croatia has provided its central bank with a clear mandate and a large degree of independence. The primary objective of monetary policy is defined as achieving and maintaining price stability, for which the CNB is accountable to parliament. The CNB is granted full instrument independence and authority over exchange rate policy. Government financing is explicitly forbidden by the law.

Table 1.

Central Bank Legal Frameworks of Croatia and Emerging Market Inflation Targeting Countries

article image
Sources: Carare et al. (2002); Croatian National Bank

Macroeconomic conditions

7. The development of the Croatian economy, as measured by GDP per capita, is similar to that of the most advanced emerging economies that have already adopted inflation targeting. After this framework was initially adopted by industrial countries in the early nineties, many emerging market countries have followed.6 Out of the thirty richest emerging market economies, eleven have already adopted it. Even though inflation targeters are characterized, on average, by higher GDP per capita, the choice of this regime is not limited to the most advanced economies. Countries like South Africa, Colombia, Thailand have opted for the same policy framework. Croatia is among the most advanced emerging market countries and its GDP per capita compares well with most inflation targeters, including other transition countries like Hungary and Poland.

Table 2.

GDP Per Capita, Emerging Market Countries, 2000 1/ 2/

(U.S. dollars)

article image
Source: IMF World Economic Outlook; Croatian National Bank

Thirty emerging countries with largest GDP per capita, excluding large oil exporters and small island countries.

Inflation targeting countries are marked in bold.

Table 3.

Croatia and Inflation Targeting Emerging Market Countries Monthly CPI Year-over-Year Inflation Before and at Adoption of Full-Fledged Inflation Targeting Framework 1/

article image
Sources: Schacchter et al. (2000); Mishkin and Schmidt-Hebbel (2001); IMF International Financial Statistics; Croatian National Bank

Month “t” is time of the adoption of full-fledged inflation targeting framework.

8. Inflation is comparatively low. Currently, inflation in Croatia is lower than in any of the emerging market inflation targeters at the time of the introduction of the new framework. Moreover, unlike all the emerging market inflation targeters at that time, Croatia has already experienced a few years of low inflation. A good track record established under exchange rate targeting is likely to have strengthened the credibility of the CNB and could help in the transition to the new regime.7

Table 4.

Fiscal and External Balances, Croatia and Inflation Targeting Emerging Market

(as a percentage of GDP)

article image
Sources: IMF International Financial Statistics; IMF staff; Croatian National Bank. 1/ Average for year of IT adoption and two preceding years.

General government.

9. While the external imbalance is well contained, the fiscal position appears very weak. Large external and fiscal imbalances can sidetrack monetary policy from its focus on the inflation target and undermine its credibility. The current account deficit in Croatia is in line with that of most inflation targeters, but its fiscal position looks particularly delicate. Among the emerging market inflation targeters, only Brazil had a worse fiscal balance at the inception of the new framework. Even though the institutional framework prevents the monetization of the deficit in Croatia, a stronger fiscal position would be required to support inflation targeting. While this constraint would be more stringent under an inflation targeting regime, fiscal consolidation is required anyway for the current policy framework to retain credibility.

The financial system

10. Despite rapid progress in the last few years, financial markets are still not well developed in Croatia. Well developed financial markets ensure better monetary policy transmission channels and allow the use of effective indirect instruments, which improve the chances of success of inflation targeting. While banks have substantially strengthened and monetization increased, markets remain shallow and highly segmented in Croatia. Credit to the private sector is held back by limited intermediation and substantial government absorption. This, however, has not prevented countries in a similar or even more problematic situation from adopting inflation targeting. This is the case, for instance, of Hungary and Poland.

Table 5.

Indicators of Financial Market Development: Croatia and Inflation Targeting Emerging Market Countries 1/

(as a percentage of GDP)

article image
Sources: IMF International Financial Statistics; IMF staff; Croatian National Bank

Average for year of IT adoption and two preceding years.

11. The situation described by indicators of financial stability is broadly similar to that in emerging market inflation targeters. Vulnerabilities in the financial system weaken the credibility of the framework by raising the possibility that central banks have to intervene to inject liquidity when the system is under stress. Despite its relatively large external exposure, the indicators for Croatia are within the range of emerging market inflation targeters and, in fact, better than those of a late inflation targeter like Hungary. In addition, Croatia has a relatively strong international reserve position.

Table 6.

Indicators of Financial Stability: Croatia and Inflation Targeting Emerging Market Countries

(as a percentage of GDP)

article image
Sources: BIS; Croatian National Bank

1/ Average for year of IT adoption and two preceding years.

12. However, the vulnerability of the financial system to sudden exchange rate movements may constitute a serious obstacle. While the direct exposure of the banking system to exchange rate risk is limited, the indirect impact is likely to be significant due the high euroization of the economy. With about half of bank loans denominated in—or indexed to—foreign currency, many firms and consumers with unhedged foreign currency positions would find themselves under stress in case of large exchange rate movements, causing substantial losses to banks.8

Monetary policy instruments.

13. The lack of depth of financial markets has prevented the development of effective policy instruments. The CNB operates mainly through foreign exchange intervention, using open market operations with CNB bills for sterilization purposes. The size of capital inflows makes sterilization difficult and complicates liquidity management. Structural excess liquidity and shallow money markets impair the effectiveness of the interest rate transmission channel, which is used by most countries that have adopted inflation targeting.

Table 7.

Operating Targets and Main Instruments of Monetary Policy of Emerging Market Inflation Targeting Countries

article image
Sources: Carare et al. (2002)

14. The high level of euroization limits the options available to monetary policy. High under former Yugoslavia, euroization has increased with the macroeconomic instability that accompanied the war in the early nineties. Foreign currency makes up about 74 percent of total currency in circulation and deposits (Kraft, 2002). Under these circumstances, monetary policy is severely limited. Its options are constrained by the vulnerability of the financial system to exchange rate volatility and its effectiveness is weakened by the importance of balance sheet effects in the transmission mechanism.9 However, if euroization is limited to asset substitution (i.e., foreign currency is held as a store of value) and does not involve widespread indexation of the economy to the exchange rate, targeting the exchange rate may not necessarily be the best option.10 11 Indeed, other countries characterized by a similar situation, like Peru, have opted for some form of inflation targeting.12

C. Conclusions

15. Most of the conditions that would support the introduction of inflation targeting seem to be present in Croatia. The institutional framework for central bank independence has been fully established, price stability has been achieved and maintained for some time, the external imbalance seems well contained, and financial markets have strengthened considerably.

16. However, the high euroization and the weakness of policy instruments are a constraint, and the fiscal position a concern. The prudential implications of high euroization are substantial and any change in monetary policy regime would have to be accompanied by further strengthening of the banking system. The absence of an effective interest rate instrument does not in itself prevent the adoption of inflation targeting, but further efforts are certainly required to develop financial markets and strengthen the transmission mechanism. The fiscal position undermines the credibility of any monetary policy regime. Further consolidation is necessary, while institutional changes could be envisaged to reinforce the medium-term orientation of fiscal policy.

17. Even if a shift to full-fledged inflation targeting may be premature, additional exchange rate flexibility would be desirable. While the central bank could continue to intervene in the foreign exchange market to prevent sudden movements not justified by fundamentals, a less activist approach to intervention could help discourage speculative capital inflows and reduce medium-term inflationary pressures. If accompanied by strong and clear communication to the public, it would also help reduce risks to financial stability that the erroneous perception of exchange rate inflexibility may entail.

references

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  • Berg, A. and E. Borensztein, 2000, “The Choice of Exchange Rate Regime and Monetary Target in Highly Dollarized Economies,” IMF Working Paper 00/29 (Washington: International Monetary Fund).

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  • Bernanke, B.S., Laubach, T., Mishkin, F.S., and A. Posen, 1999, “Inflation Targeting: Lessons from the International Experience” (Princeton: Princeton University Press).

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  • Mishkin, F.S. and K. Schmidt-Hebbel, 2001, “One Decade of Inflation Targeting in the World: What Do We Know and What Do We Need to Know?” National Bureau of Economic Research Working Paper No. 8397 (July).

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  • Schaechter, A., Stone, M., and M. Zelmer, 2000, “Adopting Inflation Targeting: Practical Issues for Emerging Market Countries”, IMF Occasional Paper No. 202 (Washington: International Monetary Fund).

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  • Sonje, V. and M. Skreb, 1997, “Exchange Rate and Prices in a Stabilization Program: The Case of Croatia,” in M. Blejer and M. Skreb (eds.) Macroeconomic Stabilization in Transition Economies (London: Cambridge University Press, pp. 212-33).

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  • Stone, M., 2001, “Aspectos prácticos de la adopción de un esquema de metas de inflación en economías emergentes: Posibles implicancias para el Perú”, Revista de Estudios Economista, Banco Central de Reserva del Perú (June).

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1

Prepared by Leo Bonato.

2

For a review of the Croatian stabilization program, see Sonje and Skreb (1997).

3

Even though inflation in Croatia is lower on average. See Billmeier and Bonato (2002).

5

A comprehensive analysis of these conditions is in Schaechter et al. (2000); and Carare et al. (2002).

6

For a survey of inflation targeting in industrial countries, see Bernanke et al. (1999). For emerging countries, see Schachter et al. (2000) and Mishkin (2000).

7

Even though the large and persistent euroization and the evidence of significant exchange-rate-related currency substitution seem to indicate that credibility gains have been limited (Kraft, 2002).

8

Even though quantitative assessments are difficult to derive due to the lack of information, the stress testing exercise conducted under the FSAP (see the FSSA report) estimates that a 15-percent depreciation would cause serious difficulties to the least capitalized banks.

9

A tightening of policy, say, may not have the desired effect if the financial position of residents holding euro-denominated debt improves as a result of the ensuing exchange rate appreciation.

10

Billmeier and Bonato (2002) estimate of a low exchange rate pass-through to domestic prices in Croatia and interpret it as evidence of limited indexation of wages and prices to the exchange rate.

11

Berg and Borensztcin (2000) show that the implications of asset substitution are equivalent to those of capital account openness. Ize (2001) argues that inflation targeting is feasible even under these circumstances as long as the cost effects of an interest rate increase dominate the balance sheet effects.

12

Peru has started a mild form of inflation targeting in 1994 (Mishkin and Schmidt-Hebbel, 2001). A discussion of the issues confronting monetary policy in Peru is in Stone (2001).

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Cover IMF Staff Country Reports
Republic of Croatia: Selected Issues and Statistical Appendix
Author:
International Monetary Fund
Volume/Issue:
Volume 2002: Issue 179
Publisher:
International Monetary Fund
ISBN:
9781451817355
ISSN:
1934-7685
Pages:
100
DOI:
https://doi.org/10.5089/9781451817355.002