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‘Visionary’ tactics cushion the blow

Croatia has not been immune to the global liquidity squeeze, but measures taken by its central bank in recent years to avoid an uncontrolled build-up of foreign debt mean the banking system may be less vulnerable than some of its local counterparts. Writer Nick Saywell.
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As if growing uncertainty over Croatia’s EU entry date and the murder of a journalist investigating alleged government corruption were not bad enough, the credit crunch has begun to claim victims among eastern Europe’s overextended economies at an alarming rate. In a banking sector dominated by foreign-owned institutions, foreign currency lending had taken off in Croatia, potentially exposing borrowers and lenders alike in the event of a liquidity squeeze and exchange rate shock.

But unlike other eastern European countries, the financial authorities in Croatia had started sounding the alarm bell some years ago. In 2004, faced by Croatia’s strong credit growth which was fuelling the increase in foreign debt as Croatian banks took advantage of cheap funds from abroad, the Croatian National Bank (HNB) commenced a series of monetary measures designed to reduce these problems and also tackle the country’s high euroisation rate (measured by the share of foreign currency deposits, including kuna deposits indexed to the exchange rate, see chart overleaf).

Not only have the measures proved successful in achieving these goals but they have also ensured that Croatia’s banking system is in better shape than its regional peers to withstand many of the ill effects of the credit crunch.

As Boris Vujcic, deputy governor of the Croatian National Bank, explains, classic monetary measures were not appropriate for the Croatian system. “The classic textbook of monetary economics simply doesn’t work in a situation where we have high euroisation, high foreign bank penetration and high credit growth due to the rapidly growing economy,” he says.

“More than 90% of the banking system is foreign-owned and if you were to increase interest rates, that would not mean much to the banking system because the banks would refinance at the ECB [European Central Bank] rate. Because of that we had to come up with some measures that are a little unorthodox but in the end worked very well.”

The measures that the HNB introduced were a marginal reserve requirement, a revised capital adequacy measure, and finally compulsory purchase of HNB paper for banks with credit growth of greater than 12% annually.

The first of these measures, the marginal reserve requirement, was levied on foreign deposits at a rate of 28% initially but now 17%. “In this way you’re making foreign borrowing more expensive and in a way regaining reasons for independent monetary policy,” explains Mr Vujcic, “because what you do then with the price of domestic money matters more once you have also made foreign borrowing more expensive.”

New capital adequacy criteria were then introduced at the end of 2005, requiring banks to make higher provisions for borrowers in foreign currency whose receipts were in kunas and were unhedged, meaning almost all retail customers as well as many corporates, hence increasing the attractiveness of loans denominated in the local currency. “In the past two and a half years, kuna lending has increased and foreign exchange lending has decreased,” says Mr Vujcic. “This has made the whole system less risky because it’s a balance sheet effect and the risks that come from that balance sheet effect become small.”

Following the new capital adequacy decision, the level of euroisation, which had been consistently around the 85% mark, fell dramatically to 75% over the next year as banks heavily marketed higher yielding kuna deposits. Today it is approximately 70%.

Restrictions on lending

However, the introduction of these first two measures did not result in a reduction of credit growth, which was still rising in 2006, and so the HNB introduced a third measure at the beginning of 2007, directly targeting this growth, which was the compulsory purchase of HNB bills, with a yield of 0.25%, for banks recording annual credit growth of more than 12%.

“What we got by the other measures was basically a change in the composition of the currency of lending and a slowdown in foreign borrowing,” says Mr Vujcic. “But it was not enough, we had to introduce this measure to really slow down credit growth.”

The introduction of this measure proved effective, with credit growth falling from 23% in 2006 to 15% in 2007 and 6.1% in the first nine months of 2008. But it has proved unpopular with banks, particularly those wishing to increase their market share.

Anton Starcevic, chief economist at Raiffeisenbank Croatia, which has grown organically from its founding in 1994 to hold 11.2% of the Croatian market, says: “It means competition is not open, and puts the banks with established market share and with established domestic deposits in a much better position than new competitive banks that are acquiring the market.”

Marijana Trpcic-Reskovac, management board member of Karlovacka Banka, a small regional bank looking to expand nationally, also highlights the problems this is causing her bank: “[The measure] is not just 12% a year, it is 1% a month, which is even worse because you have to analyse your growth; you have to say to your client, ‘You have to be patient, you have to wait,’ which is impossible to do in the market because the client has his own plans that he wants to do this month and not in four or five months.”

This restriction resulted in a surge of cross-border lending as Croatia’s mostly ­foreign-owned banking sector arranged loans for their clients directly with their parent banks or associated companies abroad. As this possibility was not available to households, the growth rate of households’ borrowing has fallen since the beginning of 2007 while that of corporates has remained largely unaffected.

Banks forced to recapitalise

Consequently, the structure of Croatia’s foreign debt has changed. Overall, foreign debt is still rising, up to €35.4bn ($44.4bn) in August 2008 from €31.1bn a year earlier. Measured as a percentage of GDP, the rise in foreign debt has slowed. From 2002 to 2004, when the HNB introduced the marginal reserve requirement, it rose from 61.9% to 80%. Subsequently the rate of the rise has tapered off, with the ratio reaching 87.8% at year-end 2007.

However, while the foreign debt of the state, which currently finances its needs on the domestic market, and that of the banks is actually declining, all the recent growth has been fuelled by a rise in indebtedness abroad of the corporate sector, which now represents more than 50% of the total. This has not just been a result of the banks’ cross-border lending activities but also Croatian companies borrowing from foreign parents.

Mr Vujcic puts this into context: “If we had allowed the debt to continue then at the moment we would probably have a debt-to-GDP ratio of more than 100%, but we have managed to stabilise it and actually Croatia, compared with its peer group of countries, is now somewhere in the middle.”

One other effect of the marginal reserve requirements has been recapitalisation of Croatian banks over the past two years. The share capital of Croatian banks grew rapidly from CrK12bn ($2.1bn) at the beginning of 2006 to CrK28bn in March 2008. This is because Tier 1 capital is not subject to the marginal reserve requirement and so the cost of funds to the Croatian subsidiary is lower. “From the parent bank’s point of view there is very little difference between giving senior debt or giving capital,” comments Mr Starcevic, “but for us it is a very big difference.”

Mr Vujcic is happy about the recapitalisations: “For us as regulators it is a much better way of financing growth, through equity rather than through debt, and it also makes the banking system at the moment much more sound when this crisis has erupted.”

Negative outlook

With the onset of the credit crisis, the ratings agency Standard & Poor’s revised the outlook on Croatia from stable to negative, reflecting “risks to Croatia’s leveraged economy of a sudden withdrawal of external financing, and the resulting complications for the exchange rate regime and economic performance”, according to S&P analyst Ana Mates.

On the positive side, Croatia at least did not suffer the fate of other central and eastern Europe countries it regards as its peers such as Bulgaria, Romania, Lithuania or Latvia, which were all downgraded by S&P, nor that of Hungary, which was put on negative credit watch.

“There are several factors that kept Croatia from being downgraded in relation to its peers,” says Ms Mates. “One of them includes the measures that the central bank has put in place in recent years, which have led to lower credit growth in Croatia [15% in 2007] compared with its peers in the region such as Romania and Bulgaria and, by association, lower growth in the banking sector’s exposure to external financing. Additionally we have seen a decline in euro loans and a growth in kuna loans as a consequence of the central bank measures.”

Ms Mates also cites the HNB’s tighter regulation of leasing companies and the strong commitment of Croatian banks’ foreign parent banks to the Croatian market as positive factors in Croatia’s favour. Additionally, the current account in Croatia is more moderate than in many peers.

“If the central bank measures were not in play the situation would have been worse; I definitely think we view these as positive measures,” concludes Ms Mates. However, she is more downbeat on large Croatian corporates who have financed themselves through cross-border loans which she believes will be hit in the credit crunch.

Despite S&P’s action, Marko Skreb, chief economist and strategist of Privredna Banka Zagreb, Croatia’s second largest bank, says that the Croatian banking sector is still very strong. “The capital adequacy ratio is more than 15% [which is almost double the Basel standard],” says Dr Skreb. “The banking system has very high international reserves, the system is subject to a high reserve requirement and above all has been managed under cautious policies – no subprime, no financial innovations, reliance on domestic financing, strict prudential policies resulting in plain vanilla banking.”

Liquidity in reserve

Mr Vujcic also feels that the Croatian banking system is in good shape to face the current financial crisis. “With these instruments of monetary policy we are also very well prepared for what is going on today in the financial markets,” he says, “because we do not depend on foreign refinancing as much as most other countries. We can now relax some of these instruments that we have put in place because there is reserve liquidity with the central bank. In this way we can simply provide some cheap liquidity to the banking system, for a long time if necessary.”

Liquidity in the system has been strengthened by another HNB measure, a minimum liquidity requirement whereby banks have to keep 28.5% of all their foreign-exchange liabilities in liquid foreign-exchange assets.

“This is important because it presents a liquidity buffer for the economy which is heavily euroised,” explains Mr Vujcic. “If you have a highly euroised liabilities side of bank balance sheets then the central bank cannot fully act as the lender of last resort, because of course we can create kunas but we can’t create euros. So when there are disturbances, the banks can use this liquidity buffer relatively quickly in case of need.”

Mr Starcevic sees the state of Croatian banking sector as healthy compared with the rest of Europe, which he attributes to the HNB’s policies. He says: “Without these measures, when the problems with liquidity started I think we would have been very vulnerable as a banking sector – maybe not like Iceland but somewhere between normal European countries and Iceland.

“As it is, the banks in Croatia have an average capitalisation ratio of about 15%, and I think the level of capitalisation of European banks will go up to more than 10% in the next year, just to stabilise the banking business in Europe. The Croatian National Bank is a visionary.”

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Read more about:  Central & Eastern Europe , Croatia