Republic of Croatia
Selected Issues Paper
Author: International Monetary Fund
Publication Date:
01 Jul 2011
eISBN:
9781455293698
ISBN:
9781455293698
Language:
English
Keywords:
ISCR; CR; debt; liability; currency; net; household debt; sound debt management strategy
Download PDF (727.6 KB)

Croatia’s economic vulnerability is discussed in this study. Using the balance sheet approach (BSA), this paper analyzes Croatia’s overall and sectoral vulnerabilities. Croatia’s financial sector balance sheet is exposed to liquidity, contagion, and currency risks. With strong pre-crisis prudential policies and parent banks’ willingness to keep or even increase exposures, the economy’s capacity to tackle another major macroeconomic or financial shock is limited. Given the stable exchange rate policy, a consistent set of structural, fiscal, monetary, and prudential policies are needed for sustained growth and reduced vulnerabilities.

Abstract

Croatia’s economic vulnerability is discussed in this study. Using the balance sheet approach (BSA), this paper analyzes Croatia’s overall and sectoral vulnerabilities. Croatia’s financial sector balance sheet is exposed to liquidity, contagion, and currency risks. With strong pre-crisis prudential policies and parent banks’ willingness to keep or even increase exposures, the economy’s capacity to tackle another major macroeconomic or financial shock is limited. Given the stable exchange rate policy, a consistent set of structural, fiscal, monetary, and prudential policies are needed for sustained growth and reduced vulnerabilities.

An Assessment of Balance Sheet Risks in Croatia1

With large external and foreign currency indebtedness and limited reserves, Croatia’s economy is highly vulnerable to macroeconomic and financial shocks. While most of these vulnerabilities were built up during the pre-crisis boom years, the crisis has further worsened the situation, exposing Croatian economy’s weak fundamentals and a lack of policy space. A sustained recovery hinges on improving competitiveness, maintaining market confidence, and reducing vulnerabilities, which would require a multi-faceted macroeconomic and structural policy response.

I. Background

A01ufig01

External Debt, Financing Needs and Reserves

Citation: IMF Staff Country Reports 2011, 160; 10.5089/9781455293698.002.A001

Sources: Croatian National Bank; IMF, World Economic Outlook; and IMF staff estimates and calculations.

1. Croatia’s economy is highly vulnerable. External debt reached 100 percent of GDP in 2010. In addition to posing risks, such high indebtedness also acts as a drag on growth. Empirical research shows that over one half of defaults on external debt in emerging market countries since 1970 occurred at levels of debt 60 percent of GDP or less. Debt stock above this level also slows down a country’s growth performance markedly (Reinhart and Rogoff, 2010). Against these benchmarks, Croatia’s external indebtedness stands far beyond what is prudent for an emerging market country. High indebtedness has also kept Croatia’s debt service payments and external financing requirements large (particularly in light of low export base), exposing Croatia to adverse developments in the international capital market. Similarly, high and rising public debt poses medium-term sustainability concerns.2 At the same time, the level of foreign exchange reserves, has fallen behind rising short-term liabilities. These vulnerabilities, which emanate from a high external debt stock, large financing needs and limited reserves, are further accentuated by a highly-euroized domestic financial sector.

2. Much of these vulnerabilities were built up during the pre-crisis years of 2002-07 when Croatia experienced a credit boom largely funded by external capital inflows. Croatia’s net International Investment Position (IIP) deteriorated sharply during this period reaching -93 percent of GDP at end-2007 (Table 1). This massive deterioration was caused by a more-than-doubling of gross external liabilities relative to GDP, as gross foreign assets slightly improved. While foreign direct investment (FDI) was a major contributor, about a quarter of FDI inflows were in the form of borrowing from mother companies making debt the largest element in Croatia’s external liabilities.3 Since 2007, increased cross-border borrowing by corporates has magnified the external debt further. At end-2010, Croatian economy’s large negative net external financial balance is mostly due to its corporate sector (Table 2).

Table 1.

Croatia: International Investment Position, 2001–10

(Percent of GDP)

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Sources: Croatian National Bank; and IMF staff calculations.
Table 2.

Croatia: Sectoral Net Financial Positions 2000–10

(Percent of GDP)

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External liabilities do not include equity capital and reinvested earnings.

Source: For 2000 and 2005, SM/07/39, and for 2009 and 2010, Tables 3 and 4.

3. Using the Balance Sheet Approach (BSA), this paper analyzes Croatia’s overall and sectoral vulnerabilities.4 We look at the disaggregated balance sheet data from the central bank, public sector, and financial and non-financial private sectors for 2009 and 2010 (Tables 3 and 4). Financial assets and liabilities are disaggregated into domestic and foreign currencies, and into short and long-term maturities. The following analysis fleshes out the key vulnerabilities in each of these four main sectors. The discussion also offers some policy recommendations.

Table 3.

Croatia: Net Intersectoral Asset and Liability Positions, December, 2009

(Millions of Croatian kuna)

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Table 3.

Croatia: Net Intersectoral Asset and Liability Positions, December, 2009 (continued)

(Millions of Croatian kuna)

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Sources: Croatian National Bank; Ministry of Finance; and IMF staff estimates.1/ Includes trade credit/advances, settlement accounts, new equity of households in life insurance and pension funds (if applicable).2/ 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.
Table 4.

Croatia: Net Intersectoral Asset and Liability Positions, December, 2010

(Millions of Croatian kuna)

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