This Selected Issues paper highlights key policy challenges for accelerating growth on a sustainable basis and reducing external and financial vulnerabilities in the Republic of Croatia. A significant reduction in public expenditure would be needed to simultaneously provide room for cutting taxes, boost growth, and lower the budget deficit to help narrow the current account deficit. The analysis finds that Croatian banks are not necessarily passing on the higher risk of foreign exchange-linked loans to unhedged clients by charging higher interest rates.

Abstract

This Selected Issues paper highlights key policy challenges for accelerating growth on a sustainable basis and reducing external and financial vulnerabilities in the Republic of Croatia. A significant reduction in public expenditure would be needed to simultaneously provide room for cutting taxes, boost growth, and lower the budget deficit to help narrow the current account deficit. The analysis finds that Croatian banks are not necessarily passing on the higher risk of foreign exchange-linked loans to unhedged clients by charging higher interest rates.

IV. External Debt and Balance-Sheet Vulnerabilities in Croatia 1

A. Introduction

1. In the past six years, Croatia’s external debt jumped by over 25 percent of GDP to reach around 86 percent of GDP at end-2006. Alarm bells are somewhat muted by Croatia’s solid economic performance, continued access to international capital markets and expectations of upcoming membership in the European Union. Still, the comment by Deutsche Bank (2005) perhaps best sums up the nagging concerns of outsiders—“Croatia’s true Achilles heel is external debt…more worrying than the amount of debt, however, is the speed of its increase.”2 Croatian policymakers have also paid increasing attention to external debt, cutting back on public foreign borrowing and discouraging external borrowing by the private financial sector.

2. This chapter explores how intersectoral vulnerabilities have shifted with the surge in external debt. To date, much of the discussion on the burgeoning debt has focused on Croatia’s aggregate position with respect to the rest of the world, with less attention paid to differences across domestic sectors and to intersectoral linkages. A more formal analysis of the balance-sheet related vulnerabilities of Croatia’s main economic sectors is one of the central themes of this Article IV consultation, and is the main subject of this paper.3

3. The rest of the chapter is organized as follows. Section B describes Croatia’s external debt dynamics and associated risks. Section C introduces the Balance-Sheet Approach (BSA), describes the construction of the balance-sheet matrices for Croatia and analyzes net financial positions at the aggregate and sectoral levels. Section D presents the sensitivity analysis of the private sector’s balance-sheet to the debt rollover, interest and exchange rate shocks. Section E concludes with a discussion of policies to mitigate the balance-sheet related vulnerabilities.

B. Croatia’s External Debt

4. Croatia has had roughly a decade of access to international capital markets. In its first few years of independence, Croatia’s main priorities were rebuilding its economy after the war and regularizing its relations with foreign creditors. Following the Paris Club rescheduling in 1995, Croatia received its first international credit rating (investment grade) and launched its first Eurobond in early 1997. A succession of programs with the IMF helped and Mihaljek (2004). to frame economic policies and facilitated access to capital markets, rather than serving as a source of balance of payments support—of SDR 1.1 billion potentially available from the Fund, Croatia drew only SDR 58 million. Achieving milestones along the route to European Union accession also served to bolster market confidence.4

5. Large financing needs, including for economic reconstruction, prompted heavy external borrowing by the public sector and, subsequently, by the private sector. The initial tapping of foreign markets by the public sector was vigorous, as reflected in the steep rise of public debt from 17 to 29 percent of GDP during 1998–2000. During the same period, the private sector’s external borrowing was relatively stagnant. However, the situation changed dramatically over the next years, with the public external debt-to-GDP ratio drifting below the peak of 2000 and the private sector’s external debt shooting up to over 60 percent from 33 percent of GDP, led by commercial bank borrowing.

6. Concerns about the rapid increase in external borrowing prompted the authorities to take action. The slowdown in public external debt accumulation, in part, reflected a deliberate policy to reduce the government’s reliance on external financing. In an effort to slow private sector borrowing from abroad, the central bank adopted a number of measures (with prudential considerations in mind, see Table IV.5, Appendix II) aimed at increasing the cost of external funding. For example, banks were required to deposit, without remuneration, a progressively larger proportion of borrowed funds at the central bank. However, since 2000, steps have not been taken to directly limit external borrowing of the non-financial private sector.

7. The level and dynamics of Croatia’s external debt raises a number of red flags. In general, high levels of external debt and debt service burden raise concerns about current account and external debt sustainability. Sensitivity analysis of external debt dynamics to plausible but low-probability adverse events—current account, interest rate and real exchange rate shocks—show that external debt ratio can shoot up to 90–100 percent of GDP.5 Moreover, high level of short-term external debt (by remaining maturity) exposes a country to debt-rollover risk in the event of a “sudden stop” in capital flows. Finally, heightened debt sustainability and debt rollover concerns tend to raise the cost of external borrowing and may ultimately increase the likelihood of a balance of payment crisis.6

8. A review of key lessons from past balance of payment crises suggests that certain combinations of macroeconomic and financial imbalances, as well as rigidities in the policy framework, tend to increase the likelihood and severity of crises. In recent emerging market crisis episodes, countries that turned out to be most vulnerable to external shocks typically had inflexible exchange rate regimes, current account and/or fiscal deficits and balance-sheet weaknesses in the private and/or public sectors. Despite its stable macroeconomic performance in recent years, Croatia seems to have many of these features: the exchange rate is fairly inflexible, fiscal policy is not all that nimble, the current account deficit is persistent (above 5 percent of GDP) and the fiscal balance remains in deficit (now close to 3 percent of GDP). The external debt-to-GDP ratio is high (well over 80 percent of GDP), and continues to rise on the back of private sector borrowing. All of the above underscores the importance of having reliable information on the balance-sheet positions of Croatia’s main economic sectors, which would help to identify potential pressure points and risk transmission mechanisms in the event of a negative shock.

C. The Application of the Balance-Sheet Approach to Croatia

9. The balance-sheet approach (BSA) is a way to analyze the economy as a system of interlinked sectoral balance sheets. While traditional macroeconomic analysis is typically concerned with aggregate flow variables(such as fiscal and current account balances), the balance sheet approach focuses on stocks(such as asset and liability positions).7 Clearly, the two approaches are interrelated. Typically, the starting point in the BSA is the construction of detailed balance sheets of the main economic sectors (public, private financial, private non-financial, households and non-residents), enabling assessments of maturity, currency, and capital structure mismatches, as well as intersectoral linkages.

10. The BSA can provide important insights into balance-sheet mismatches which may exacerbate a country’s vulnerability to shocks. One example is foreign currency debt between residents, which is netted out of a country’s aggregate balance sheet, but which may result in foreign currency payments problems between residents in the face of adverse shocks. If a government, for example, is unable to roll over its hard currency debts to residents and must draw on foreign currency reserves to honor its debts, the drop in reserves could jeopardize the ability of other sectors to service their external obligations on time. In such circumstances, foreign lenders may decide to curtail their financing as well. With a liberalized capital account, a decline in market confidence could fairly quickly trigger net capital outflows. Close financial linkages between domestic sectors increase the likelihood that difficulties in one sector can spill over into healthy sectors.8

11. For Croatia, the balance-sheet matrices were constructed for end-2000 and end-2005 (Tables IV.1 and IV.2), spanning the period characterized by a surge in external debt. For each year, Croatia’s economy is disaggregated into nine sectors—the central bank, central government, state and local governments, public non-financial corporations, other depositary corporations, other financial corporations, private non-financial corporations, other residents, and nonresidents. The balance-sheet matrix displays each sector’s claims on other sectors as well as its liabilities to other sectors (all intra-sectoral assets and liabilities are netted out). Financial assets and liabilities are broken down by currency (domestic and foreign currency) and by maturity (short and long-term). Because not all assets and liabilities are included in the BSA matrix (more on this below), each sector’ total assets may not be equal to its total liabilities. Further data collection is required to fill in the remaining gaps.

Table IV.1.

Croatia: Net Intersectoral Asset and Liability Positions

(In millions of Kuna)

(December 2000)

article image
Table IV.1.

(continued) Croatia: Net Intersectoral Asset and Liability Positions

(In millions of Kuna)

(December 2000)

article image
Sources: Croatian National Bank, Ministry of Finance, and authors’ estimates.

Includes trade credit/advances, settlement accounts, new equity of households in life insurance and pension funds (if applicable).

Claims of ODCs do not include 0.5 billion kuna of currency holdings and 4.3 billion kuna of non-financial assets; Liabilities of ODCs do not include 14.6 billion kuna of equity contributions by owners and 10.3 billion kuna of loss provisions.

Table IV.2:

Croatia: Net Intersectoral Asset and Liability Positions

(In millions of Kuna)

(December 2005)

article image
Table IV.2:

(continued) Croatia: Net Intersectoral Asset and Liability Positions

(In millions of Kuna)

(December 2005)

article image
Sources: Croatian National Bank, Ministry of Finance, and authors’ estimates.

Includes trade credit/advances, settlement accounts, new equity of households in life insurance and pension funds (if applicable).

Claims of ODCs do not include 2.2 billion kuna of currency holdings and 5.4 billion kuna of non-financial assets; Liabilities of ODCs do not include 23.8 billion kuna of equity contributions by owners and 8.8 billion kuna of loss provisions.