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Trying to turn the taps back on

Croatia entered the financial crisis with its banking sector in good shape, but rising unemployment and fiscal pressures are dampening new lending activity. Writer Nick Saywell
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Trying to turn the taps back on

Goran Saravanja, chief economist at Croatia's largest bank, Zagrebacka Banka, is contemplating something of a novelty for the country's banking sector. "This is the first recession in Croatia's modern history where the banking sector has not been the main cause; actually, it's been a source of stability," he says.

At the Croatian National Bank (HNB), Boris Vujcic, the deputy governor, ascribes the stability to the central bank's monetary policy it has been following over the past few years. "It is the combination of the measures we have had in place - primarily the capital charge on credit growth over 12%, which effectively brought down the credit growth," he says.

"We did not have excess credit growth, which would have increased vulnerabilities in terms of accumulating more foreign debt, because most of these credits in central and eastern Europe are financed by inflows of foreign savings and the accumulation of foreign debt. Because of the lower rate of credit growth, the potential increase of non-performing loans [NPLs] post-crisis is also reduced," says Mr Vujcic.

The HNB also allowed foreign parent banks to provide capital to their subsidiaries without provisioning requirements, but required provisioning if that funding was in the form of loans instead. This resulted in a doubling of foreign-owned banks' capital in the two years prior to the crisis. The average capital adequacy ratio is 15.8%, well above the 10% minimum.

Mr Saravanja acknowledges the positive role of the HNB but feels the banking sector itself should share the credit. He says the difference between this recession and the previous one in 1999, when the banking sector was shown as "extremely weak", is the wave of bank privatisations in the meantime, which left only one major bank not in foreign hands.

"If you look at the foreign liabilities in the fourth quarter of 2008 you will see they rose by €2.5bn," says Mr Saravanja, "which is to say that foreign banks, the owners of Croatian subsidiaries, basically provided that capital when it was required. They did so because this is a profitable, well-run, professional banking sector, and a one-off factor such as the Lehman bankruptcy and the effect it had on the global environment was not a reason to abandon Croatia," he says.

As a result, Croatia did not find it necessary to enter an agreement under the Vienna Initiative brokered by the multilateral organisations in March 2009. These agreements aimed to prevent foreign banks withdrawing funds in return for multilateral backing of the country's economy, and other states in the region, including Serbia, Bosnia-Herzegovina and Romania, sought to tie in foreign banks through such deals.

Navigating the slowdown

Despite this strength and stability, Croatia's banking sector was unable to avoid negative effects from the 5.8% decline in gross domestic product (GDP) in 2009. Pre-tax profits in the sector as a whole fell by 24.9% to Hrk4.3bn (€590m). The difference of Hrk1.4bn is more than explained by increased provisioning costs for NPLs of Hrk2.4bn. Return on equity for the year was 6.7%, down from 9.9% in 2008.

The fact operating profits before provisioning rose in 2009, says Mr Saravanja, is "a great sign of the strength and maturity of the sector". Two important factors he gives for this increase is a reduction in costs and an increase in trading profits resulting from increased volatility on the money markets. Zagrebacka Banka's pre-provisioning profit rose 6.9% to Hrk2.1bn but overall the bank saw a 13% drop in pre-tax profits to Hrk1.5bn.

Not all banks saw a fall in profits. Splitska Banka, owned by Société Générale, is Croatia's sixth largest bank. Its CEO, Pierre Boursot, says: "While in the banking sector pre-tax income decreased, Splitska Banka managed to increase pre-tax income by 13.7%, despite the deteriorating economic environment. This is even more respectable if we bear in mind the financial results of our main competitors that recorded a double-digit decrease of pre-tax income at the same time."

As its name suggests, Splitska Banka was a regional bank based in Split, Croatia's second city. However, it is now trying to become more of a national bank. "Although we are aware of the changed circumstances in the Croatian market, our goal remains to increase the market share, especially in north Croatia, without a deterioration of assets," says Mr Boursot.

Meanwhile, Zdenko Adrovic, CEO of Raiffeisenbank Austria, expresses his satisfaction that the bank's fall in profits in Croatia was lower than average, decreasing 17% to Hrk499m. He attributes this resilience to trading gains. "With the performance of trading assets above market average, Raiffeisen realised a lower fall than the market and partially compensated for the decline of the credit portfolio result."

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Optimistic: Zdenko Adrovic, CEO, Raiffeisenbank Austria

Prospects for 2010

Mr Adrovic has some optimism for this year. He does not expect a further increase in NPLs overall, but notes that the picture varies between the retail and corporate segments. "This year looks better because capital flows are unfrozen, credit availability is normalised and uncollected receivables are stable. But on the retail and small business side, especially for private individuals, increasing unemployment cancels the positive effect on the corporate side. We expect retail provisioning costs to peak in 2010," he says.

Unemployment in Croatia stood at 317,625, or 18.3%, in February this year, a rise of 54,804, or 21%, from February 2009. Overall, Mr Adrovic expects 2010 profits to be similar to those of 2009, barring any negative surprises from the world markets.

However, Mr Boursot is not quite so optimistic. Interest margins have begun to narrow as loan demand falls and funding costs rise. "Despite the strong increase of interest rates on loans, net interest income decreased in 2009 in the banking sector. While interest expenses increased by 12.5%, interest income increased by less than 5%. With provisions likely to increase in 2010, we see a further decrease of profitability in this year," he says.

The declining rate of lending to the corporate sector has been a distinguishing feature of 2009. Mr Adrovic provides two different explanations. "First is the decrease of clients' creditworthiness. A company's sales volumes usually decline during a crisis. Its debt and profitability ratios are worsening, causing a fall of the client rating and credit limit. Hence, even without any change in banks' lending policies, clients' credit limits have to shrink. The second negative impact comes from the banks' unwillingness to lend to companies with results that are elastic to the market crisis, before a significant economic recovery is certain. It definitely shrinks the list of companies accepted under the lending policy," he says.

Mr Saravanja's GDP forecast for 2010 is a further fall of 1% followed by a rise of 1.3% in 2011. Faced with coming out of recession a year behind many other European countries, the Croatian authorities are anxious to promote increased lending to local business to help lead the country back to growth.

Croatian bank lending statistics

Croatian bank lending statistics

Stimulating lending

So, after years of monetary policies designed to dampen credit growth, the HNB now finds itself in a position where it is trying to encourage the commercial banks to increase lending. The tool it has chosen to do this is the mandatory reserve requirement, which was lowered from 14% to 13% on February 3, 2010. This reduction released some Hrk2.9bn, of which about Hrk2bn was channelled to loan auctions conducted by the Croatian Bank for Reconstruction and Development (HBOR), a state-owned development bank.

Mr Vujcic says the HNB has agreed a policy by which the reserve requirement will be reduced again to 12% if all the funds released to the HBOR by the first reduction are successfully allocated in the auctions. Upon further success, the rate will be finally cut to 11%.

The idea behind the auctions is twofold. First, they are intended to channel money into the real sector to help get the economy moving again. To further this purpose, criteria have been introduced as to the eligibility of companies for these loan funds in order to see the money being spent on revenue-generating projects rather than on just reprogramming old debts. Second, by sharing the risk with the banks and participating in the loan with its lower interest rates (thanks to its quasi-sovereign funding costs), HBOR wants to see cheaper funds on offer to participating businesses. The final loan to the company is a syndicated loan with both HBOR and the winning banks participating.

Average short-term interest rates on kuna loans to enterprises stood at 7.56% just before Lehman Brothers filed for bankruptcy, according to HNB figures. These climbed to more than 10% for much of 2009 but have now started to fall and stood at 8.31% in January this year.

Auction launch

The first two HBOR auctions were held in February and March this year, and each resulted in Hrk200m being allocated by HBOR under its 'Model A' auctions for working capital. This resulted in loans to the final users at interest rates varying from 4.34% to 5.11%. The first 'Model B' auction for longer-term investment projects was held in mid-April and also was allocated Hrk200m.

Although the lower internal rates of return attached to such loans should make more projects worth submitting for this source of finance, it is not clear whether the HBOR auctions will have the desired effect of increasing the amount of loans actually made to the corporate sector.

"I believe success is more possible in the area of lower interest rates than in spreading loans to risky clients. The potential result is to boost clients already prepared for business growth, by increasing their competitiveness. Risky clients will not benefit from the HBOR auctions," says Mr Adrovic.

Mr Vujcic admits that the tools of monetary policy are much more effective in limiting credit growth than in promoting it. Perhaps as a result, in its press release announcing the mandatory reserve requirement, decrease the HNB stated: "Banks should contribute towards initiating a long-term recovery of the economy, instead of focusing on their own short-term interests, charging maximum possible interest on all types of placements."

Mr Boursot rejects the assertion that the banks are being short-sighted. "We see that most of the banks in Croatia have acted wisely so far," he says. "Without a strong economy there is little chance for successful banking business, and we intend to support the recovery of the domestic economy.

"Splitska Banka actively participated, along with the Ministry of Finance, HNB, HBOR and other business banks, in the implementation of the schemes to support financing of the corporate sector. We proved our willingness to support the Croatian economy by bidding for the available funds with lowest margin at the first HBOR auction."

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Pierre Boursot, CEO, Splitska Banka, owned by Société Générale

Debt issues

The difficulty is that banks are not the only people from whom companies may be having increasing difficulty getting money - customers are also paying late. The so-called liquidity crisis in Croatia has seen the total of debts past their due date rise to Hrk27.4bn at the end of January 2010, according to the figures of the government's Financial Agency. This is a rise of 45% from January 2008.

"The term 'liquidity problem' is wrong," says Mr Vujcic. "This is simply financial indiscipline which means that in Croatia you can delay payments to your suppliers without consequences, without penalties that are high enough. In order to prevent this, you should really make the cost of such delinquency higher than the benefit." He sees the solution in legislation and increased court efficiency.

Fiscal pressures

Against the backdrop of falling GDP, increasing unemployment and businesses in difficulty, the government's fiscal policy has come in for criticism. August 2009 saw an increase both in value-added tax from 22% to 23%, and in payroll taxes, with the introduction of a 'crisis tax' which has now been partially withdrawn. It is predicted the budget deficit for 2010 will be Hrk8.6bn, but figures for the year to date show income undershoots and expenditure overshoots, resulting in speculation that minister of finance Ivan Å uker will be forced to revise his deficit forecast upwards.

"Unfortunately, the government failed to recognise the crisis in time. The result is non-adapted budget expenses and crowding out of the banks' lending capacity to corporates. That is a reason why interest rates on banking loans have been high during the whole of 2009, completely against the anti-recession goals," says Mr Adrovic.

Mr Adrovic says the effect of higher taxes is "to lower private consumption and postpone structural reforms" he thinks are necessary for the recovery. Mr Boursot shares these concerns. "Dynamic economic growth in this decade made the fiscal authorities a bit dormant and they faced the recession not only with unsustainable dynamics of public expenditure growth, but also with an extremely unfavourable structure of expenditure," he says.

"We believe strong fiscal consolidation is much needed in the upcoming period, not just to 'weather this storm' but also to increase competitiveness and support development of the private sector."

Mr Å uker is currently fighting the country's unions about his proposals to cancel Christmas bonuses and other benefits enjoyed by public-sector workers, which would save some Hrk640m from the budget, but Mr Saravanja believes that more serious reforms will be delayed.

"I would characterise the economic policy debate as quite defensive in the sense that it's all about saving jobs or anti-recession measures. For me it hasn't moved to the next stage, which is what we need to do to generate growth. The answer is the private sector, which is still waiting for a signal for concrete signs on which to base its optimism," he says.

Mr Saravanja believes the impetus may have to wait until Croatia opens the chapter on competition policy in its EU accession negotiations, now expected to happen in July. Whether that means a start will be made on structural reforms in 2010 is not known, but Mr Saravanja sounds a note of cautious optimism: "I wouldn't bet that nothing will happen this year."

Bankers in the dock

The past few months have seen Croatia rocked by many corruption scandals that have been investigated and for which charges have been brought by USKOK, the Office for the Suppression of Corruption and Organised Crime.

Domestic considerations aside, corruption has been highlighted by the EU as an area that must be tackled if Croatia is to complete its accession negotiations. The chapter on judiciary and fundamental rights has yet to be opened and, according to the EU 2009 Progress Report for Croatia: "While the total number of corruption cases investigated so far has increased, the actual number of prosecutions remains low. There has been limited investigation of high-level corruption, the prosecution of which is frustrated by political influence. A culture of political accountability for the corruption uncovered by USKOK is lacking."

There have been procurement scandals involving state electricity monopoly HEP, Croatian Railways and Croatian Motorways, which are still under investigation. But the biggest scandal to date has been the so-called 'Spice' affair. This resulted in the March 2010 arrest of Damir Polancec, economics minister and deputy to former prime minister Ivo Sanader until forced to resign after the affair came to light while Jadranka Kosor was prime minister.

Mr Polancec is accused of a number of financial abuses, including trying to organise the purchase of Podravka, Croatia's largest food manufacturer, with the company's own money, channelling various loans via Hungary to companies in Croatia, and approving the sale of a 47% stake in Croatian oil company INA to Hungarian peer MOL for corrupt reasons. That 2008 sale is now under review by the Croatian state attorney, and could be revoked.

The banking sector has not been immune. The 'Bankomat' affair resulted in the arrest in January 2010 of Josip Protega, former CEO of the Croatian Postal Bank (HPB), and other senior bank officials. HPB is the only state-owned bank among the country's big eight and also the only one of them to have posted losses in 2009. Mr Protega has been accused of approving loans, bypassing normal lending criteria, to certain companies which allegedly had political approval.

Another affair, under investigation in Austria, relates to Hypo Group Alpe Adria Bank, which had to be rescued by the Austrian government in December 2009. The Austrian State Attorney's office has confirmed business dealings involving Croatia are central to its investigation. Mr Sanader is alleged to have lobbied on behalf of Hypo, which is suspected of money-laundering in Croatia.

If called upon, HNB governor Zeljko Rohatinski has acknowledged his readiness to testify about Mr Sanader's lobbying, which is alleged to relate to the sale of Hypo to Germany's BayernLB in 2007.

The re-entry of BayernLB to Croatia required Mr Rohatinski's authorisation, after the bank had earlier been banned from the country for financial misconduct.

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Read more about:  Central & Eastern Europe , Croatia