EU accession was meant to bolster Croatia’s economic prospects, but it is yet to have a positive effect on the country's flagging economy. Meanwhile, its banks are facing poor asset quality and a difficult operating environment.

The year 2013 was not a propitious one for Croatia or its banking industry. As the country’s gross domestic product (GDP) sank for a fifth successive year, its banks remained in the black but saw profits tumble 73% to Hrk757m (€99m), according to the Croatian National Bank.

Naturally, the two are linked, says Alen Kovac, chief economist at Erste Bank Croatia. “There are two key drivers, one being the lengthy recession and the NPLs [non-performing loans] coming from economic activity. There are also one-offs, one being the new pre-bankruptcy procedure allowing some debt relief, which has increased the dynamics of NPLs affecting banks. The other one-off is regulatory, because the central bank has demanded that the banks have higher provisioning for their NPLs.”

Zdenko Adrovic, CEO of Raiffeisenbank Austria, says there may be more bad news yet to come this year for banks. “In 2014, NPL growth seems possible given weak economic growth prospects, still-declining real estate prices, elevated and still rising unemployment, and delayed bankruptcies in corporate sector."

Also affecting the banks is lower net-interest income resulting from a squeeze on margins and a lower loan base as businesses and households deleverage. The banks are having to adjust to the situation. “The extended period of low growth in sales has already refocused strategic goals from increasing income to decreasing operating and risk costs,” says Mr Adrovic.

Class action

The highest profile event in the Croatian banking sector in 2013 was a court ruling in July in favour of a class action against the country’s eight leading banks for a breach of consumer rights regarding loan agreements linked to the Swiss franc. The banks imposed massive interest rate rises on those loans when the franc appreciated in 2010 and 2011.

The action was brought by Potrosac (the Croatian Consumers Association) and the Udruga Franak association formed by bank clients with Swiss franc-linked loans. “The majority of banks are owned by western European parents, and are applying double standards in how they treat their customers at home and here,” says Ilija Rkman, president of Potrosac. “That is what we are fighting against.”

The banks have appealed the verdict and the case could drag on through various layers of courts for years, but the potential liability dwarfs any profits the banks have made in recent years. “About 75,000 mortgage borrowers could be compensated €20,000 on average, and the 50,000 or so who took out short-term loans could get on average €6000 to €7000,” estimates Nicole Kwiatkowski, a lawyer who acted for Udruga Franak in the case.

Following the Potrosac/Franak case, the government entered the fray, passing a new Consumer Credit Act which came into force on January 1, 2014. This act – seeking in the words of the Ministry of Finance to prevent “the arbitrary and unilateral raising of interest rates by the banks” – imposes statutory limits on loan interest. The interest rate on Swiss franc mortgages is fixed at 3.23%, barring currency fluctuations of 20% or more, which Mr Adrovic notes is below the cost of funding, negatively impacting bank revenues.

Excessive deficit

On the macroeconomic front, whether Croatia will at last return to growth in 2014 will be a close-run thing. Both Mr Adrovic and Mr Kovac forecast zero GDP growth for the year. Even the government, whose growth estimates for the past two years wildly exceeded both analysts and reality, is only predicting growth of 0.2%. Standard & Poor’s expects a sixth year of recession and once again cut Croatia’s sovereign rating in January, to BB from BB+.

As a result of its continuing budget deficit and new EU membership, Croatia’s economy is now under the watchful eye of the European Commission under the excess deficit procedure. As a result, the government is already having to amend its 2014 budget as it tries to find a way to reduce its deficit – 5.9% in 2013 and predicted by the commission to hit 6.4% this year on current policies – to the 4.6% agreed with Brussels.

“It is possible to attain these goals only by strong fiscal consolidation accompanied by reforms of big public systems such as healthcare, education and social welfare,” says Mr Adrovic. “The recent government plan for fiscal consolidation is mostly focused on the revenue side. Reforms are not planned and that is definitely not enough to improve economic prospects.”

As well as some revenue-raising measures coming into immediate effect, the government has announced further taxes to be introduced in 2016, on property, capital gains and interest income. Since it came to power in December 2011, the government has already raised VAT twice and boosted revenues by clamping down on the grey economy, directly linking cash tills via the internet to the tax authorities.

The government hopes renewed economic growth will be led by investment. But in addition to fiscal cuts, consumer spending has been subdued. Household sector deposits have risen more than 25% since the crisis began despite a lower capacity to save.

“The government is hoping that increased investment from the public sector and state-owned companies may be able to kick-start the process, and that private sector and foreign investment will follow,” says Mr Kovac.

Two new laws have been passed to help stimulate investment. An investment promotion act provides tax breaks and other incentives for job creating investments, and a strategic investments act aims to fast-track investments of more than Hrk150bn, preventing local bureaucratic obstacles from stalling those projects.

Investment drought

Whether this will translate to increased investment activity in the short term seems doubtful. “[There is a] lack of quality projects for financing and investments are still being postponed. Unfortunately, we do not see a significant change in this trend in the near future on the domestic market,” says Balazs Bekeffy, CEO of OTP Banka Hrvatska.

Mr Kovac adds that part of the corporate sector still has too much debt on its books but companies looking to invest have a good opportunity. “Good clients, especially those that have a five-year track record and have survived the recession, are in a solid position to get cheap funding,” he says.

Dr Ante Babic, secretary-general of Croatia’s Foreign Investors Council, says: “The new investment laws are a step in the right direction and therefore welcome. However, the two biggest problems for foreign investors are the labour laws, which are among the most inflexible in Europe, and a tax regime that keeps changing.”

The government put a new labour bill – already watered down due to union pressure, according to Mr Babic – into parliamentary procedure in January and the unions responded by gathering support from their members for a general strike. The final shape of the law is not yet known.

Mr Babic is not confident that foreign direct investment will increase in the immediate future. “On the contrary, we are doing what we can to make sure the investors who are already here do not leave,” he says. “We are not asking for special treatment, just that the government does what is necessary to improve the business climate for all companies in Croatia.”

False hopes?

One factor which was hoped would give Croatia a boost was EU membership. The country became the 28th member state of the EU in July last year. However, Mr Adrovic does not see any benefit as yet.

“On the contrary, the market positions of companies with significant shares of income from the export of goods were negatively affected by the changes in operating conditions following accession to the EU. The preferential status in the Cefta [central European free trade area] market has been lost, reducing the competitiveness of Croatian exporters from the food and beverages industry. At the same time, it became easier for producers from other EU members to supply goods and services in the local market.”

A further measure by which the government plans to close the budget gap is privatisation and this includes the financial sector. A majority stake in Croatia Osiguranje, the country’s largest insurance company, is being sold and the government also offered Hrvatska Postanska Banka (HPB) for sale. HPB is Croatia’s seventh largest and last major state-owned bank.

Both OTP Banka and Erste Bank participated in the bidding for HPB, but the only binding offer came from Erste Bank and was rejected by the government as too low. However, whereas OTP Banka failed to buy market share from the government, it succeeded in the private sector with its purchase of Banco Popolare Croatia (BPC) in January this year, and there may be more to come.

“Financial sector consolidation will continue on the Croatian market in the mid-term, and will concern not only small banks such as BPC, but mid-sized and large financial institutions as well,” says Mr Bekeffy, who adds that OTP would like to grow further. “We would be interested in new, quality acquisitions if the opportunity arises,” he says.

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