Download operational framework of monetary and macroprudential

OPERATIONAL FRAMEWORK OF MONETARY AND
MACROPRUDENTIAL POLICY IN SMALL OPEN AND
EUROISED ECONOMY: CASE OF CROATIA
Marijana IVANOV, PhD
Faculty of Economics and Business Zagreb, J. F. Kennedy Sq. 6, 10 000 Zagreb, Croatia
[email protected]
Abstract
The recent global financial crisis has drawn attention to various factors of financial
instability including the pro-cyclicality of banks’ lending activity, the pro-cyclicality in asset
price movements, the vulnerability of small open developing countries on internal and
external shocks associated with sudden inflow and outflow of foreign capital etc. All this
engenders the behaviour that is impossible to shape by standard instruments of monetary
policy and microprudential measures alone without taking into account the accumulation and
materialization factors of systemic risk in the financial system at whole. A general consensus
is that a macroprudential approach should be adopted with more direct influence on the
supply of loans, the quantity and quality of bank capital and maintaining an adequate level of
bank short-term and long-term sources of liquidity. In cases of small open economies it also
involves instruments characterized by quasi capital controls, limitations of currency
mismatches between bank assets and liabilities (especially in the case of countries with high
level of financial euroisation) as well as the implementation of specific non-standard
instruments with stronger effects on the growth of bank claims in periods of business
upswings and downswings.
Key words: monetary policy, macroprudential policy, financial stability, Croatian monetary
and banking system
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Introduction
The development of the financial crisis has encouraged the discussion on the formerly
neglected issues such as the pro-cyclicality of bank lending policies, the pro-cyclicality in the
use of leverage by banks and other sectors, the pro-cyclicality in asset price movements as
well as the pro-cyclicality in cross-border capital flows. All this generates behaviours that
cannot be shaped by standard instruments of monetary policy and microprudential measures
(supervision of banks focused on characteristics of single financial institutions) which leads to
a widely accepted attitude that a macroprudential approach should be adopted with more
direct influence on the supply of loans, particularly on their relation to the changes in the
collateral value, on the disposable income of the debtors as well as on the capital and liquidity
reserves of banks (Hanson, 2011). The primary purpose of the macroprudential policy is to
limit the accumulation of systemic risks which can be related to many sources of instability in
the financial system both in general and in the real sector. The macroprudential authority
should be able “to adjust its policy tools dynamically, to counter the build-up of risks during
upswings and attenuate credit contraction and excessive risk-aversion in
downturns“(Angelini, 2012).
The recent global financial crisis has revealed the weaknesses of the monetary policy focused
solely on price stability while neglecting other aspects of financial stability, as well as the
volatility of asset prices and the strong growth of bank lending activity in circumstances of
higher economic growth that took place in the absence of inflationary pressures prior to 2007.
The expansionary monetary policy in large developed countries and the parallel liberalization
of cross-border capital flows had also enabled strong external borrowing and growth of the
financial sectors in small open developing countries in the period between 2000 and 2007,
which augmented their sensitivity to various financial disturbances including the systemic risk
that has become visible from 2008 to date.
On the other hand, small open countries could be significantly vulnerable to internal and
external shocks associated with sudden inflows and outflows of foreign capital (foreign
currency net-inflows) that affect their monetary and banking systems. Those could stimulate
their imposing of specific quasi capital controls (Habermeier et all, 2011), although in
practice they were implemented in the form of monetary policy instruments with
macroprudential characteristics (Radošević, 2013). In the case of Croatia’s monetary system
prior to 2008, this meant applying monetary instruments in the function of limiting the
excessive external debt of the banking system, limitations of the currency mismatches
between bank assets and liabilities, specific liquidity requirements related to foreign currency
assets and liquid marketable assets as well as the implementation of different limits on
excessive growth of bank claims in the period of economic prosperity.
In addition, due to large-scale of deposit euroisation and credit euroisation in Croatia, all
measures and instruments in the domain of the banks’ monetary and prudential regulation are
always formed to stabilize the exchange rate (between the Croatian kuna and the euro) and
maximize the resilience of the banking system on the currency-induced credit risk (Galac,
2010). This also includes the prudential regulation with higher minimum capital adequacy
ratio for banks in Croatia (12% at the end of 2013) than in other European countries and,
particularly today on Croatia’s becoming an EU member, different requirements in the
domain of internal bank capital maintenance. Practically, it also includes a twenty-year
tradition of the stable exchange rate as the main precondition for simultaneously preserving
price stability and the stability of the financial system as a whole.
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By combining the described measures with the parallel practice of high reserve requirements
on banks’ liabilities, the Croatian National Bank has been very successful in maintaining a
high degree of stability in the banking system as well as in preserving the exchange rate
stability and price stability in last twenty years. However, the question that arises is whether
this is enough to achieve general financial stability in the future if we take into account a
number of parallel disorders in the real sector of Croatia’s economy including large external
debt, heavy indebtedness of households and of a part of the business sector, high public debt
and excessive budget deficit, high propensity to import and low competitiveness of exports in
international trade, negative GDP growth in the last five years accompanied by high
unemployment rate and the lack of prospects for revived economic activity in the domestic
business sector over the long term. The purpose of this paper is to analyse the performance of
the coordinated implementation of monetary and macroprudential policies in the earlier and
current practice of the Croatian National Bank and to explore in which way they can be more
successful in preventing negative developments in the real sector and in achieving long-term
financial stability.
Twentieth anniversary of monetary stability
In the spring of 2014 Croatia’s monetary system marks the twentieth anniversary of monetary
stability with an average year to-year inflation of about 3%, which is certainly a great success
if we remember the monetary history in the year 1993 when the average annual inflation rate
exceeded 1,000% (CNB). The breakdown of the former hyperinflation (trough the
Stabilisation Programme in October 1993) and the later monetary stability has been achieved
by a strategy of stable exchange rate as the nominal anchor for price stability. For this purpose
the national central bank intervenes in the foreign exchange markets, preventing excessive
appreciation or depreciation of the domestic currency, although not to defend a certain level
of the exchange rate (Lang; Krznar, 2004). Practically it also includes tolerance for a strong
national currency and aversion to its weakening, because cheaper imported goods make
pressure on the decrease in average inflation rates. This is the reason why the exchange rate
policy of the Croatian National Bank is often subject to criticism of a wide range of scholars,
professionals, and managers from domestic export-oriented enterprises. Nevertheless, general
conclusions about the exchange rate policy in Croatia are partially dangerous because of the
different conditions that affected the monetary framework and the development of the
exchange rates in three separate periods of the last twenty years: 1) achievement of monetary
stability in 1994 – 1999; 2) 2000 – mid-2008 and 3) beginning of global financial crisis in
second half of 2008 – today.
The late 1990s were characterized by the transition process through which Croatia was to
create stable conditions for shifting to market oriented economy. The main characteristics of
this period were:
- slow monetary growth and very restrictive monetary policy based on the high level of
required reserves on bank deposits (for example, the weighted average of the required
reserve ratio was 35.92% at the beginning of 1997) as well as on maintaining a stable
exchange rate as a nominal anchor for price stability but at a level that was favourable
to the growth of net imports of goods and services;
- the limitation of central bank lending to the government;
- establishment of the central bank functions as ‘the lender of last resort’ rather than as a
source of liquidity for problem banks;
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undeveloped banking system with the dominant position of state owned banks and
with relatively poor quality of their loans portfolio inherited from the socialist era in
the former Yugoslavia;
relatively low public confidence in the domestic banking system due to bad
experiences with the collapse of the savings system in the former Yugoslavia as well
as two waves of banking crises in the 1990s
changes in the fields of external and internal financial liberalization;
development of the financial markets and non-banking financial institutions;
abundance of former barriers of international trading and cross-country inflows of
foreign capital;
stronger growth in imports and fall in exports of goods and services (e.g. current
account deficit reached the level of 10.5% of GDP in 1997) due to the adverse
conditions of international trading partly resulting from overvalued domestic currency
as well as from many structural problems in the domestic economy that did not
respond to the global changes in a timely manner;
neglected development of the domestic industry and agriculture with over-reliance on
tourism and trade activities as a source of income for a growing portion of the
population; and
poorly conducted privatization process with a significant loss in the employment and
industrial capacities.
Influenced by the negative memories from the monetary history of the period up to 1993
(including frequent devaluations of the domestic currency in the period of the former
Yugoslavia), Croatian citizens favoured saving in foreign currencies deposits in banks and a
significant share of their assets was held in foreign currencies (in the form of cash) at home.
At the same time the domestic currency was more exposed to potential depreciation pressures.
Thus, the monetary policy was limited due its orientation to exchange rate stability as an
anchor for maintaining the price stability. The official foreign currency reserves were very
low hindering monetary growth. Consequently, prior to 2000 the bank loans were scarce and
very expensive creating a discouraging framework for the private sector borrowing as well as
for investment activities and economic growth.
Monetary framework after cross-border capital flow liberalisation
Significant changes in Croatia began in 2000 as a result of the liberalization of foreign direct
investments and the suspension of former capital controls creating new and larger possibilities
for the domestic sector borrowing internationally. With each further of capital account
liberalization, Croatia become more integrated in the global financial system (especially in the
financial system of the euro area) but with a relatively low increase in foreign direct
investments and a huge increase in external debt. As the ownership structure of banks saw
significant changes, the share of bank assets in foreign ownership reached 84% in total assets
of the banking system in 2000. Higher public confidence in the banking system (and
especially in foreign-owned banks) caused a significant increase in savings with banks.
Additionally, frequent practices of banks borrowing abroad (typically from the foreign parent
banks located in the euro area) enabled growth in domestic lending activity and lowering
interest rates on all types and maturities of bank loans.
In the period from 2000 to 2007 bank loans to households, especially housing loans, increased
by six times, while loans to non-financial corporations increased by 2.7 times (CNB, 2014).
Credit growth was accompanied by increase of average nominal net wages and better living
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standard for higher-income share of households, by higher employment in the public sector,
as well as intensive growth of the real estate prices in big cities and along the Adriatic coast.
Since the real estate is the typical collateral for banks’ lending activities, the increase their
market value supported the growth of bank loans while simultaneously the increasing growth
of housing loans supported the rise in real estate prices. Thus, the real estate prices in
attractive geographic positions in Croatia virtually doubled from 2000 to 2007. The same
trend was also noted in several peripheral countries in the euro area, i.e. in Greece, Ireland,
Portugal and Spain from 1999 to 2006, where a sharp fall in interest rates was noted
„following their euro area accession, combined with an easy access to cross-border
borrowing“ (Brzoza-Brzezina et all, 2013). However, insufficient attention is paid to possible
macroprudential measures that can be used to stop too high growth of housing loans either by
limiting foreign borrowing, either by binding the restrictive loan-to-value ratios or by higher
minimum capital adequacy ratio.
Between 2002 and 2007 Croatia recorded a slightly higher average rate of GDP growth, 4%
per annum (Central Bureau of Statistics). The economic growth was primarily affected by
increases in personal consumption, activities in the construction sector, trade and tourism as
well as by an increase in government spending. On the other hand, the potentials for higher
economic growth and development were hindered by low and dawdling increase of
investment in fixed capital (especially in domestic industrial production activities) as well as
by continued deficit in the international trade – which has accompanied by almost continuous
growth of external debt.
Along with the growth of external debt and foreign currency inflows connected with the
privatization of former state-owned enterprises or new foreign investments, Croatian official
international reserves recorded a significant growth after 2000. In the period 2000 – 2012 the
official international reserves increased by 4 times while the gross external debt increased by
3.6 times (CNB). Economic growth between 2002 and 2007 thus took place under the
conditions of continuous deficit in the current account balance of payments that was financed
by much larger surplus in the capital account. All this created a continuous pressure on the
appreciation of domestic currency in the period prior to October 2008 and stimulated the
central bank to intervene on FX market to maintain the stability of the exchange rate (between
the Croatian kuna and the euro). In this way the central bank tried to create as much as
possibly tolerant conditions for the international trade in order to avoid a stronger fall in the
exports of goods and services. Seen from today's position in this manner the central bank has
formed a high stock of international reserves that have facilitated the preservation of the
financial stability in the last five years of recession and the accompanying adverse
developments in the financial sector.
For the period between 2000 and mid-2008 it is important to note that the domestic currency
would have been far more overvalued without the central bank’s purchases of foreign
exchange from banks in order to maintain the exchange rate stability. However, due to still
too strong domestic currency as well as the other factors positively impacting the growth of
imports of goods and services (greater propensity to import, increase in nominal net wages,
the greater availability of bank loans for car purchases and fierce competition of cheaper
imported final and intermediate goods in general), the high deficit on the current account of
the balance of payments was a continuous feature of the Croatian economy prior to 2010.
From 2002 to 2008 currency account deficit fluctuated between 7.3 and 9.0 percent of the
GDP but it started to decrease after 2009 when Croatia entered into a state of protracted
recession.
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In case of Croatia it is unrealistic to deliberate about positive effects of the foreign direct
investment on the sustainable economic growth as most of them have focused on the sectors
that are not export-oriented and contributed to the growth of imports of goods and services
directly or indirectly, creating adverse conditions for survival and a higher market placement
of domestic industrial and agricultural output. Between 1993 and 2013 over 70% of all FDI in
Croatia involved investments in the financial intermediation (banks dominantly), wholesale
and commission trade, real estate activities and investments, telecommunications and retail
trade. An additional problem is the low share of Greenfield against equity investments
(Jovančević, 2007) as well as the low share of FDI versus large external debt. In the period
1993 – 2012 the FDIs reached the scale of 5.994 euros per capita, which is almost fifty
percent less than in Estonia and 25% less than in the Czech Republic. The main reasons are as
follows: the relatively unfavourable business climate that has characterized the Croatian
economy from 1990s but became prominent from 2009, relatively higher labour costs
compared to other European countries (expressed in euros and influenced by the existing
exchange rate which maintains a strong national currency, labour costs in Croatia are over
30% higher than in Hungary and Slovakia, and twice as much as in Romania and Bulgaria),
low productivity of the domestic production, high tax pressure incurred by the costs of the
huge public sector, rigidities in the labour market, excessive administrative regulations and
restrictions that affect the business sector, insufficient possibilities of economies of scale in
production for the domestic market as well as the strong national currency in terms of euro
and other foreign exchanges as one of the factors diminishing the competitive opportunities
for exporting.
Essentially from the implementation of the Anti-inflation Stabilization Program in October
1993 to the present time Croatia’s monetary system has featured the specific characteristics of
a quasi (or unofficial) currency board but with manage floating stable (not fixed) exchange
rate. The total money supply M1 is typically over the 125% covered by the official
international reserves (today 150%), while the central bank’s purchases of foreign exchange
from banks (and selling domestic currency) have represented the main (or even the only)
channel of primary money creation as well as the main instrument of liquidity providing to
banks starting from 1994. The situation is analogous today, but the intensity of the FX
transactions is smaller and often in opposite direction due to certain depreciation pressures on
the domestic currency following October 2008. Other monetary tools like outright open
market purchases of government securities have never been employed, while bank
collateralized borrowing from the national central bank is always expensive, scarce and
available on very short term, typically only overnight or on seven days through reverse repo
transactions. At the same time, a large required reserve represents the main instrument by
which the central bank sterilize too large amount of bank sector liquidity in domestic currency
(created by the central bank’s foreign exchange transactions in order to achieve the exchange
rate stability). After 2001 the required reserve ratio has been reduced several times but it is
still higher (12% in April 2014) than with the ECB or other central banks in the developed
countries, while the base for calculating the banks’ obligatory reserves cover 95% of all bank
liabilities including the collected deposits and other sources of financing (except capital).
The nominal exchange rate anchor strategy significantly constrains the manoeuvring
possibilities of the monetary policy. In order to maintain the exchange rate stability, it should
create more favourable monetary conditions at the time of high inflows of foreign capital that
caused the appreciation pressure on the domestic currency (as, for example, in the period
2000 – 2007 characterized by a high increase in external debt). Conversely, the monetary
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policy becomes restrictive in times of depreciation pressure (like in the period after the
collapse of Lehman Brothers and at the beginning of the global financial crisis that limited the
possibilities of non-financial corporations and banks to borrow cheaply abroad and
consequently reduce the net-inflows of foreign currency in Croatia). This is typical for all
monetary systems that employ the strategies of nominal exchange rate anchor as the
precondition for price stability (Végh, 2013). However, in Croatia the exchange rate stability
is important not only to preserve the price stability, but additionally to preserve the overall
financial stability as the country’s banking system is characterized by a high degree of deposit
euroisation (at the end of 2013 f/c deposits accounted for approximately 80% of all deposits)
and loan euroisation (about 70% of all bank loans and 90% of housing and other long-term
loans to residents were indexed by currency clause).
Although the banks are principally unexposed to currency risks (as their foreign currency
liabilities are covered by loans indexed to foreign currency), they are heavily exposed to
currency-induced credit risk which can be manifested in case stronger depreciation of the
domestic currency jeopardizes the abilities of the domestic entities in debt servicing,
especially of the households whose revenues are remunerated dominantly in the national
currency. After 2010 the manifestation of such currency-induced credit was observed for
loans indexed to the Swiss franc, which notably includes a significant share of housing loans
and recorded the strong growth of non-performing loans after 2011. For example, at the end
of 2013 the share of NPLs for housing loans indexed to the euro was 4.88%, while NPLs’
share for housing loans indexed to the Swiss franc was 12.36% (CNB, 2014).
A further problem with negative consequences of a potential depreciation is the large external
debt, especially in the case of the government and in a significant part of the domestic
business sectors that receive no revenues in foreign currency (non-exporters) but prefer
borrowing abroad due to low cost of financing. However, partially this is not the case for the
construction sector because the prices of flats and other real estate in Croatia are typically
expressed and negotiated in euro.
Monetary policy with features of macroprudential approach
The significant part of Croatia’s external debt was cumulated in the period from 2000 to 2007
– characterized by relatively cheaper and stimulating borrowing terms in the euro area due to
expansionary monetary policy of the ECB, especially between 2003 and 2005. Another
significant part of the external debt was cumulated after 2008 as a result of tightening of the
monetary conditions in Croatia and of overly expansionary fiscal policy with strong growth of
the internal and external public debt in the recent years. The total gross external debt of all
sectors reached the level of 75% of GDP and 180% of export of goods and services in 2007
(CNB) and continued growing until 2009 when by all criteria Croatia entered the category of
highly externally indebted country. Today external debt is at the level of 100% of the GDP
and over 220% of exports of goods and services (CNB, 2014). The largest part of the external
debt includes the debt of private and public non-financial corporations, while a significant
portion of the external debt is attributed to banks, leasing companies, factoring companies,
state development bank and central government.
In order to limit the growth of banks' external debt, in the period 2004 – 2008 the monetary
policy implemented the marginal required reserves and the special required reserves as nonstandard instruments that penalize banks’ raising funds through foreign borrowing channels.
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Both of them represent a specific form of quasi capital controls although it is quite clear that
in circumstances of liberalized international capital flows they could not stop the growth of
total external debt especially in the case of non-financial corporations’ external debt.
However, these specific instruments achieved certain effects with features of macroprudential
policy including lower leverage of banks and increased banks’ funding by additional
capitalization (to avoid the reserve requirement that penalized foreign debt financing while
contributing to higher capital adequacy rate recorded for the entire banking system) as well as
by the reduction of currency mismatch between their assets and liabilities (the main part of
the banks’ liabilities are f/c deposits of residents and debt to non-residents, while their claims
are typically in domestic currency but indexed to a foreign currency). Another effect was
ending excessive lending to domestic non-banking sectors due to the increase of regulation
costs for banks and consequently higher interest rates on bank loans.
In year 2006 the central bank additionally introduced an instrument of compulsory purchase
of central bank’s bills to limit the permissible growth of bank claims at a rate of 1% per
month, which essentially represented a form of required reserves on bank assets as well as an
additional monetary policy instrument with possible macroprudential features. Essentially the
same group of instruments that assumes coordination between the monetary and the
macroprudential policies could also include high reserve requirements on which basis the
Croatia national bank achieves many standard and non-standard effects (depending on the
general environment during the periods of upswings or downswings in business/financial
cycles). They include the following impacts:
• restricting banks’ lending capacity in circumstance of high RR ratio (and the creation
of manoeuvring space for potential future decreases of RR ratio in periods when the
central bank is required to increase the liquidity of the banking system to stimulate
economic growth or reduce the pressure of deflation);
• reducing the money multiplier because the significant share of monetary base include
immobilized required reserves of banks;
• sterilizing monetary effects of foreign exchange purchases from banks;
• sustaining high system reserves to preserve the stability of the financial system and
bank deposits in case of a bank run;
• maintaining a high level of international reserves managed by the central bank
(international reserves are the dominant category of assets in the balance sheet of the
central bank and a counter-balance of large required reserves in the central bank’s
liabilities);
• accumulating reserves in years of economic expansion accompanied with appreciation
pressures on the domestic currency to protect future financial stability in periods of
contraction and potential depreciation pressures;
• preventing capital outflows at times when foreign parent banks could decide to
redirect their placements on other foreign markets with higher returns on bank equity;
and
• upholding strong influence on the liquidity of the banking system and behaviour of
short-term interest rates on interbank market as well as strong influences on the
stability of the exchange rates through actions of central banks that cause the scarcity
or abundance of the domestic currency liquidity relative to foreign exchange reserves
disposed of by commercial banks.
Croatian national bank also implements the measure of the minimum required foreign
currency claims through which the central bank forces banks to hold a certain minimum
percentage of their foreign claims versus the total amount of their f/c liabilities (foreign
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currency deposits, foreign borrowing etc.). The function of this measure is to achieve the
adequate banks’ foreign currency liquidity and partly to decrease the currency risk in banking
system in general (although the banking system’s exposure to prudentially defined currency
risks is formally very low as the bank foreign currency liabilities are largely covered by loans
with a foreign currency clause). Additionally, in the same way as other instruments of
monetary policy in Croatia, this measure can be used to affect the stability of exchange rates
or to decrease the ability of banks to grant their kuna loans with or without foreign currency
indexation. Thus this measure also represents an instrument of specific macroprudential
regulation in function of preserving the stability of the financial system as a whole.
Using the minimum required foreign currency claims as a measure of monetary policy is
largely associated with deposit euroisation. Namely, despite the twenty year tradition of price
stability as well as the stable exchange rate, households and other sectors in Croatia prefer
saving in foreign currencies (especially in euro) and relatively frequently develop speculative
fears of potential stronger depreciation of the domestic currency (and in circumstances of
several-year appreciation pressure). The long-term claims of banks and other entities are
indexed to the euro, the prices of real estate and other valuable assets are often expressed in
euros although almost all payments are effectuated in the national currency.
Croatia is a specific case of an EU country with the highest degree of deposit euroisation
while in terms of loan euroisation it does not differ significantly from the other EU
transitional countries outside the euro area. The level of deposit euroisation was significantly
and continuously decreasing in the period 2004-2007, which was accompanied by greater
economic prosperity when the significant part of household savings was invested on the stock
exchange market, in investment funds or entrepreneurial activities related to the construction
of residential and tourism real estate etc., so that the share of f/c savings and time deposits
with banks was much lower. However, deposit euroisation became even more prominent in
the second half of 2008 when the domestic currency was more affected by little depreciation
pressure because of lower net-inflows of foreign capital. Another factors that have contributed
to the decline of public confidence in the national currency in favour of more deposit
euroisation is the development of the economic crisis after 2009 as well as the fact that
domestic currency is practically always over valuated what create speculation of public about
future correction of exchange rate.
Financial stability in years of recession
Croatia has recorded negative rates of GDP growth in the last five years, which were
accompanied by additional problems: raising unemployment (at the level of 20% at end of
2013), liquidity and solvency problems in case of many formerly well-performing enterprises,
the huge public debt hampered by a significant growth after 2008 (today it is at 63% of GDP
or more than 80% of GDP including the government guarantees), excessive budget deficit at
4.7% of GDP in 2013 which could reach 5.6% of GDP in 2014 (Ministry of finance, 2013),
significant decrease of personal consumption and possibilities for higher export due do global
economic crisis, reduced foreign and domestic investments due to poor investment climate
and delayed or stopped structural reforms in Croatia etc., while the deflation pressure has
become more visible by the end of the 2013.
A growing number of citizens and businesses cannot service their debt causing the
deterioration of the banks’ loans portfolios and a significantly decline of the banking industry
profitability. The NPLs reached 15.63% of all bank loans at the end of 2013, while their share
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in the case of the non-financial sector increased to 28.12%. The most difficult situation is
encountered with loans to construction, industry and trade, while in the case of loans to
households the main problem is the quality of mortgage cash loans, housing loans indexed in
the Swiss franc, and overdraft loans to holders of blocked current accounts.
The real estate prices have currently taken a downward trend and the construction sector was
hit by the economic crisis – thus decreasing the demand in this sector. Other activities,
especially the industrial productions have been affected by lower demand both on foreign and
domestic markets. Consequently, the manifestations of the crisis in the real sector have been
transmitted to the banking sector. However, generally speaking, the stability of the Croatian
banking system still remains high due to the following factors:
• a high proportion of large banks that have stronger capital, liquidity and reputation;
• as the result of better capitalizations of large banks, the average rate of capital
adequacy ratio at the level of the entire banking system is far above the minimum
prescribed (at the end of 2013 the prescribed ratio was 12%, while the actual average
rate recorded in the banking system was 20.88%);
• the pre-crisis conservative monetary policy of the CNB in combination with
macroprudential effects enabled the creation of huge official international reserves and
f/c reserves of banks as well as high required reserves and capital reserves of banks;
• through exchange rate stability (and toleration to overvaluation of domestic currency),
the central bank protects the banking system from the materialization of the currencyinduced credit risk as essentially the most dangerous risk to which the system is
exposed.
From 2008 bank lending activity was significantly reduced and later stopped which was to be
expected since the entire domestic sector suffered from indebtedness (including too high debtto-equity ratio at business sector) as a result of over-borrowing in the years of prosperity. The
average creditworthiness of households and the business sector today is too weak, which is
why certain specific growth was noted only in bank claims to government. In order to
increase the liquidity of banks and act contrary to the banks’ pro-cyclical lending behaviour,
the national central bank has decreased the required reserve ratio several times and
implemented an instrument of compulsory CNB bills as a specific bank reserve that can be
released for single banks provided that they approve double the amount of loans to nonfinancial companies. In addition, different programs of favourable bank lending to export
oriented enterprises and SMEs are active due to coordinated measures of monetary and fiscal
policy.
The implementation of compulsory central bank bills also represents an instrument of
monetary policy with macroprudential features aimed at preventing the procyclical behaviour
of banks and today it directly stimulates more lending to the non-financial sector, which is
necessary due to the long recession and deflationary gap pressures evident from the end of
2013. However, the significant constrain of such a countercyclical monetary measure is the
banks’ lack of interest to increase their lending activity in the period of economic recession,
partly because of their already high exposure to credit risk accumulated in the pre-crisis
period, because of too high debt-to-equity ratio in the case of many non-financial companies
and partly due to the lack of safe and profitable investment opportunities as well as good
debtors. The credit channel of the monetary policy expansionary transmission mechanism
therefore does not work today or work only for short-term lending; while the effects of the
interest rate channel affect only money market interest rates but due to the high risk premium
they do not spill over significantly onto long-term interest rates. On the other hand, banks
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retain huge non-return excess reserves in their settlement accounts in order to protect their
stability in case of any liquidity disorders (deposit withdrawals in larger amounts) as well as
to meet the requirements for maintaining the prescribed minimum liquidity ratio (a measure
from the domain of microprudential regulation). High liquidity in the banking system,
therefore, is not sufficient to significantly reduce cost of long-term borrowing of the real
sector and initiate investments and greater use of domestic production capacity.
One of the possibilities for the Croatian financial system includes outright open market
transactions or similar instruments of monetary policy that would enable the central bank to
buy limited amount of government securities from banks while the banks could
simultaneously buy other government securities from the pension funds with the aim of
encouraging their new investment in the private sector. On this way is possibly create the
opportunities for larger investment of pension funds in equity of non-financial corporations as
an incentive to grow of real sector investments (because the current leverage of many wellperforming non-financial corporations is still too high which makes them unattractive debtors
for banks). As pension funds are institutions with the long-term oriented investments and
lower aversion to risk, their today exposure to the negative consequences in the real economy
is different from that of banks (sources of pension funds have longer maturity and are more
stable than short-term bank deposits). So, pension funds equity investments in domestic
business sector can be possible alternative to insufficient lending activities of banks (as well
as too low foreign direct or other investments).
Described restructuring of financial institutions’ portfolios in combination with open market
operations of the central bank represent specific model of (monetary) quantitative easing in
function of economic growth. However, the question without a precise answer is whether it is
(at least to a small and limited extent) at all possible in a small, open and highly euroised
economy like Croatia. Namely, resistance to such expansionary measures reflects the public
fears of depreciation of the domestic currency, while the instability of the exchange rate could
jeopardize both price stability and the financial stability. In such circumstances, even the fact
that the national currency is overvalued (approximately 10 percents in terms real effective
exchange rate deflated by unit labour cost in industry) while real economy is affected by
recession pressure, it is unlikely that the central bank will take any radical steps to change
existing monetary condition.
Conclusion
Price stability is the main goal of monetary policy, while the primary purpose of
macroprudential policy is to limit the accumulation of systemic risks which can be related to
many sources of instability in the entire financial system as well as in the real sector. Since
the small open countries could be significantly vulnerable to internal and external shocks
associated with sudden inflow and outflow of foreign capital, they can be more interested in
the implementation of different monetary and capital controls in the form of monetary policy
instruments with macroprudential features. In the case of the Croatian monetary system this
has meant limits on banks’ excessive external debt and limits on the excessive growth of bank
claims in the period of economic prosperity prior to 2008. Today this includes limitations of
the currency mismatches between banks’ assets and liabilities, specific liquidity requirements
related to foreign currency assets and liquid marketable assets, still high required reserve to
protect the outflow of banks’ capital abroad as well as the compulsory CNB bills with the
purpose to stimulate more lending to non-financial corporations.
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Instruments of monetary policy and of prudential policy in Croatia are usually coordinated to
maintain price stability, exchange rate stability and financial stability. On the other hand,
monetary measures sometimes have different objectives then measures of prudential
supervision, but both affect the same economic categories, including bank lending, liquidity,
leverage etc. Traditional (micro and macro) prudential actions are aimed at preserving
financial stability and decreasing high credit exposure of banks. On the other hand, monetary
policy is directed towards maintaining price stability, which in the current circumstances in
Croatia means necessary actions against recession and deflationary gap pressure by
encouraging higher bank lending activities as well as by stimulating a limited depreciation of
domestic currency in function of higher competitiveness of domestic production. However,
when depreciation of domestic currency and higher lending activities of banks can have
positive effects on Croatian real economy, because of high banks’ exposure to credit risk and
especially currency induced credit risk they can destabilize financial sector. Additionally,
depreciation of domestic currency can decrease the possibilities of all sectors in servicing the
huge external debt. As result of all constrains, in spite of negative rates of GDP growth in the
last five years, the national central bank has a limited manoeuvre space for implementation of
aggressive expansionary monetary policy without potential negative effect on price and
financial stability.
Additionally, in accordance with the guidelines of the Basel regulations, today lending
activities of banks are increasingly constrained by additional capital requirements,
conservative prudential framework for management of credit risk as well as by more
conservative requirements regarding management of short-term and long-term sources of
liquidity. Such measures restrict the greater lending activity of banks – just at the time when
they can be implemented to stimulate stronger economic growth. These are the new
challenges for coordinating monetary and macroprudential policy to protect stability in the
real sector as well as to preserve the stability of the financial system as a whole.
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