## AN ASSESSMENT OF BALANCE SHEET RISKS IN CROATIA

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### Background
- External debt reached 100 percent of GDP in 2010.
- Empirical evidence: "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."
- Public debt: "high and rising public debt poses medium-term sustainability concerns."
- Reserve adequacy: "level of foreign exchange reserves, has fallen behind rising short-term liabilities."
- Pre-crisis (2002–07) deterioration in external positions:
  - "Croatia’s net International Investment Position (IIP) deteriorated sharply ... reaching -93 percent of GDP at end-2007."
  - "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."
- Sectoral net financial positions (Percent of GDP):
  - All domestic sectors: Net external position -22 -39 -54 -57
  - Central Bank: Net external financial position 18 24 23 24
  - General Government: Net external financial position -26 -22 -11 -13
  - Private non-financial sector: Net external financial position -15 -27 -56 -56
- Methodology: analysis uses the Balance Sheet Approach (BSA) and disaggregated balance sheet data for 2009 and 2010.

### The Public Sector — findings and vulnerabilities
- Public sector debt developments:
  - "Public sector debt, including debt guaranteed by the government, after declining by 10 percentage points of GDP during 2002-07, rose to 58 percent at end-2010."
- Composition and risks:
  - External share: "share of external debt in total public debt declined from 63 to 43 percent between end-2001 and end-2010."
  - Interest rate structure: "share of fixed-rate bonds in total has increased to 80 percent."
  - Short-term debt: "share of short-term debt from 7 percent at end-2001 to 17 percent at end-2010."
  - Currency denomination: "close to 60 percent of domestic public debt is denominated in or linked to foreign currency (mostly in euros)."
  - Public sector net foreign currency indebtedness: "at 19 percent of GDP, it is sizable."
  - Banking sector exposure: "The share of credit to the government, at 20 percent of total banks’ outstanding credit..."
- Guarantees:
  - "About 60 percent of the guaranteed debt is owed to external creditors, mostly by the state-owned development bank HBOR."
  - Risks: guarantees may become direct liabilities (example: shipyards restructuring).
  - Public debt management gap: "Croatia’s public debt management strategy does not cover guarantees and aims to stabilize only the direct debt."
- Policy recommendations for public sector:
  - "An expenditure-based fiscal consolidation and a sound debt management strategy remain crucial."
  - Fiscal Responsibility Law: "recently-adopted Fiscal Responsibility Law (FRL), which intends to reduce expenditure by one percent of GDP annually until a primary balance is reached."
  - Medium-term objective: "fiscal consolidation should aim to achieve a cyclically-adjusted balanced budget in the medium term."
  - Strengthen debt management to "take account of the guaranteed debt."
  - "Policies to increase domestic currency finance of public debt would be important to reduce exchange rate related risks."
  - Suggested instrument experience: replacing foreign-currency denominated and linked public bonds with inflation indexed bonds to build credibility for move to domestic currency financing.

### The Central Bank — findings and vulnerabilities
- Reserve accumulation and coverage (as of end-2010):
  - "gross and net reserves cover less than 75 and 65 percent of short-term liabilities (at remaining maturity), respectively."
  - "a portion (6 percent) of the foreign exchange reserves correspond to commercial banks’ deposits at the CNB."
  - Excluding those deposits, "the coverage of short-term debt (at remaining maturity) further reduces to below 60 percent."
  - Composite metric shortfall: "Croatia’s reserves at end-2010 are about 20 percent below the recommended minimum."
- Nature of short-term liabilities:
  - "half of all short-term maturing liabilities are due to FDI-related inter-company debt and banks’ debt to parent institutions, which carry lower roll-over risks."
- Policy implications and recommendations:
  - Given the preference for a stable exchange rate, "maintaining adequate level of reserves is critical to ensure financial stability and increase shock absorption capacity."
  - Future reserve accumulation: "going forward reserve accumulation will have to depend more on exports proceeds than in the past."
  - To raise exports and reduce vulnerabilities: "structural reforms that enhance the business environment and labor force participation, and a competitive wage policy ... bring more FDI into tradable sectors, lower Croatia’s dependence on debt financing, and facilitate reserves accumulation through higher exports."

### The Financial Sector — findings and vulnerabilities
- Liquidity and funding:
  - "loan-to-deposit ratio at 107 percent."
  - "financial sector’s net external debt stood at 10 percent of GDP at end-2010, mostly owed to foreign parent banks."
  - Parental support caveat: continued support mitigated liquidity risks, but "level and degree of support ... would depend on general market conditions and the health of parent banks themselves," posing contagion risk.
- Currency and maturity exposures:
  - "net short-term foreign currency position, at -15 percent of GDP, exposes the sector to currency risks in the short run."
  - Euroization: "share of foreign-currency linked or denominated loans at close to 75 percent, for both corporates and households."
  - Corporate short-term loans: "half of short-term loans are denominated in or linked to foreign currency."
  - Household mismatch: households "rely on kuna income" while loans are highly foreign-currency linked.
- Impact on non-performing loans (NPLs) and capitalization:
  - CNB estimate: "one percent depreciation in the exchange rate could result in a 7 percent increase in NPLs (CNB, 2010b)."
  - "recapitalization needs from a moderate downward movement in the exchange rate would be manageable without the need to raise additional capital."
- Prudential policy:
  - "CNB’s pro-active prudential policies have contributed to the stability of the financial system."
  - Measures included reducing banks’ borrowing abroad and building capital and liquidity buffers.
  - Ongoing recommendation: "maintaining strong buffers in the financial system is important to counter risks from a high degree of euroization."

### Non-Financial Private Sector
- Aggregate net positions (Percent of GDP):
  - "private non-financial sector: Net external financial position -15 -27 -56 -56"
  - "Net foreign currency position -11 -31 -62 -62"
  - "Net short-term foreign currency position 19 18 18 18"
- Implication: "At end-2010, Croatian economy’s large negative net external financial balance is mostly due to its corporate sector."

### Corporate sector leverage and vulnerabilities
- Overall net indebtedness: reached over 70 percent of GDP by end-2010.
- Maturity structure: "Roll-over pressures remain low given the mostly long-term nature of the debt."
- Currency risk:
  - "High level of net foreign currency indebtedness exposes the corporate sector to exchange rate risks."
  - New currency-indexed loans concentrated in non-tradable sector.
  - Sectoral extremes: in real estate and construction, transport, communication, hotel and restaurants — share of foreign currency denominated or linked debt "as high as 90 percent."
- Interest rate risk: "around 95 percent of total lending to corporates carries an interest rate that is variable within a year."

### Household indebtedness and vulnerabilities
- Gross household indebtedness: "41 percent of GDP and 85 percent of disposable income."
- Debt service: households spend "nearly 7 percent of their disposable income on interest payments."
- Currency composition: "about 70 percent of household debt is in foreign currency."
- Interest rate structure: "96 percent of all household loans are issued with interest rate variable within a year."
- Macroeconomic implication: High household indebtedness and deleveraging, together with sluggish labor market conditions, "pose a drag on consumption and economic recovery."

### Macroeconomic consequences and assessment
- Large balance sheet vulnerabilities across sectors "compromise Croatia’s ability to counter macroeconomic shocks and have weighed down its growth prospects."
- Crisis resilience factors: Croatia weathered the most recent crisis due to strong pre-crisis prudential policies and parent banks’ willingness to keep or increase exposures.
- Constraints:
  - Large balance sheet vulnerabilities constrain exchange rate policy options.
  - Pervasive structural rigidities and a lack of fiscal policy space diminish the economy’s ability to withstand shocks.
- Growth challenges:
  - "A small export sector is not providing the needed pull for growth."
  - Households are deleveraging.
  - "Any downturn in investor sentiment could trigger corporate sector deleveraging, prolonging the recovery."

### Policy recommendations (orderly unwinding of vulnerabilities)
- Overarching: Given the stable exchange rate policy, "a consistent set of structural, fiscal, monetary and prudential policies are needed for sustained growth and reduced vulnerabilities."
- To reduce external indebtedness and foster sustainable growth:
  - "Corrective wage and structural policies that would increase tradable sector’s contribution to growth."
  - "Policies to enhance economy-wide productivity."
  - "Measures to allow financing of external current account deficits through higher non-debt creating flows (FDI)."
- Public debt management:
  - Reduce public expenditures to achieve "a cyclically-adjusted balanced budget in the medium term."
  - "Care should be given to potential crowding out concerns and currency risks as authorities pursue greater reliance on domestic financing."
  - "Pursuit of policies to increase the share of domestic currency finance would be appropriate."
- Reserves and prudential buffers:
  - "Croatia should continue to build up reserves to enhance its ability to absorb shocks."
  - "Large prudential foreign currency buffers should be maintained to safeguard the stability of the highly-euroized financial sector."
- Financial sector resilience:
  - "Maintain strong bank capital and liquidity buffers and prudent regulation to contain currency and contagion risks."

*International Monetary Fund, Republic of Croatia, Selected Issues, Prepared by Jesmin Rahman (EUR), Approved by the European Department, June 8, 2011.*

### 2011. The views expressed in this document are those of the staff team and do not necessarily reflect

### AN ASSESSMENT OF BALANCE SHEET RISKS IN CROATIA

### Background
- Croatia’s economy is highly vulnerable with "External debt reached 100 percent of GDP in 2010."
- High indebtedness acts as a drag on growth; empirical research cited: "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."
- Public debt concerns: "high and rising public debt poses medium-term sustainability concerns."
- Reserve adequacy: "level of foreign exchange reserves, has fallen behind rising short-term liabilities."
- Pre-crisis boom (2002–07) effects:
  - "Croatia’s net International Investment Position (IIP) deteriorated sharply ... reaching -93 percent of GDP at end-2007."
  - FDI and inter-company borrowing: "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."
- Sectoral net financial positions (selected figures from Table 2, Percent of GDP):
  - "All domestic sectors: Net external position -22 -39 -54 -57" (for 2000, 2005, 2009, 2010 respectively as in table).
  - "Central Bank: Net external financial position 18 24 23 24"
  - "General Government: Net external financial position -26 -22 -11 -13"
  - "Private non-financial sector: Net external financial position -15 -27 -56 -56"
- Methodology: analysis uses the Balance Sheet Approach (BSA) and disaggregated balance sheet data for 2009 and 2010.

### The Public Sector — findings and vulnerabilities
- Public debt developments:
  - "Public sector debt, including debt guaranteed by the government, after declining by 10 percentage points of GDP during 2002-07, rose to 58 percent at end-2010."
  - Guaranteed debt share decline during 2002-07 offset by other agency behavior; but guaranteed stock rose subsequently.
- Composition and risks:
  - External vs domestic: "share of external debt in total public debt declined from 63 to 43 percent between end-2001 and end-2010."
  - Interest rate structure: "share of fixed-rate bonds in total has increased to 80 percent."
  - Short-term and currency risks: "share of short-term debt from 7 percent at end-2001 to 17 percent at end-2010."
  - Currency denomination: "close to 60 percent of domestic public debt is denominated in or linked to foreign currency (mostly in euros)."
  - Public sector net foreign currency indebtedness: "at 19 percent of GDP, it is sizable."
  - Banking sector exposure: "The share of credit to the government, at 20 percent of total banks’ outstanding credit..."
- Guarantees:
  - "About 60 percent of the guaranteed debt is owed to external creditors, mostly by the state-owned development bank HBOR."
  - Risk of guarantees becoming liabilities (example: shipyards restructuring).
  - "Croatia’s public debt management strategy does not cover guarantees and aims to stabilize only the direct debt."
- Policy recommendations for public sector:
  - "An expenditure-based fiscal consolidation and a sound debt management strategy remain crucial."
  - Fiscal Responsibility Law: "recently-adopted Fiscal Responsibility Law (FRL), which intends to reduce expenditure by one percent of GDP annually until a primary balance is reached."
  - Medium-term objective: "fiscal consolidation should aim to achieve a cyclically-adjusted balanced budget in the medium term."
  - Strengthen debt management to "take account of the guaranteed debt."
  - "Policies to increase domestic currency finance of public debt would be important to reduce exchange rate related risks."
  - Suggested instrument experience: replacing foreign-currency denominated and linked public bonds with inflation indexed bonds to build credibility for move to domestic currency financing.

### The Central Bank — findings and vulnerabilities
- Reserve accumulation:
  - "Reserves accumulation continued during the crisis, but has not kept pace with maturing liabilities."
  - Coverage metrics as of end-2010:
    - "gross and net reserves cover less than 75 and 65 percent of short-term liabilities (at remaining maturity), respectively."
    - "a portion (6 percent) of the foreign exchange reserves correspond to commercial banks’ deposits at the CNB."
    - Excluding those deposits, "the coverage of short-term debt (at remaining maturity) further reduces to below 60 percent."
  - Composite metric shortfall: "Croatia’s reserves at end-2010 are about 20 percent below the recommended minimum."
- Nature of short-term liabilities:
  - "half of all short-term maturing liabilities are due to FDI-related inter-company debt and banks’ debt to parent institutions, which carry lower roll-over risks."
- Policy implications and recommendations:
  - Given preference for stable exchange rate, "maintaining adequate level of reserves is critical to ensure financial stability and increase shock absorption capacity."
  - Reserve accumulation will need to depend more on exports: "going forward reserve accumulation will have to depend more on exports proceeds than in the past."
  - To raise exports and reduce vulnerabilities: "structural reforms that enhance the business environment and labor force participation, and a competitive wage policy ... bring more FDI into tradable sectors, lower Croatia’s dependence on debt financing, and facilitate reserves accumulation through higher exports."

### The Financial Sector — findings and vulnerabilities
- Liquidity and funding:
  - "loan-to-deposit ratio at 107 percent."
  - "financial sector’s net external debt stood at 10 percent of GDP at end-2010, mostly owed to foreign parent banks."
  - Reliance on parent banks: continued support during the crisis mitigated liquidity risks, but "level and degree of support ... would depend on general market conditions and the health of parent banks themselves," posing contagion risk.
- Currency and maturity exposures:
  - "net short-term foreign currency position, at -15 percent of GDP, exposes the sector to currency risks in the short run."
  - Euroization of lending: "share of foreign-currency linked or denominated loans at close to 75 percent, for both corporates and households."
  - Corporate short-term loans: "half of short-term loans are denominated in or linked to foreign currency."
  - Household risk: households "rely on kuna income" while loans are highly foreign-currency linked.
- Impact on non-performing loans (NPLs):
  - CNB estimate: "one percent depreciation in the exchange rate could result in a 7 percent increase in NPLs (CNB, 2010b)."
  - Current capitalization/profitability: "recapitalization needs from a moderate downward movement in the exchange rate would be manageable without the need to raise additional capital."
- Prudential policy:
  - "CNB’s pro-active prudential policies have contributed to the stability of the financial system."
  - Measures taken: to "reduce banks’ borrowing abroad and build capital and liquidity buffers" during the boom years.
  - Ongoing recommendation: "maintaining strong buffers in the financial system is important to counter risks from a high degree of euroization."

### Non-Financial Private Sector
- Aggregate vulnerability (from sectoral data):
  - "private non-financial sector: Net external financial position -15 -27 -56 -56" (for 2000, 2005, 2009, 2010 respectively as in table).
- Currency exposure:
  - "Net foreign currency position -11 -31 -62 -62" (2000, 2005, 2009, 2010 respectively).
- Short-term maturity exposure:
  - "Net short-term foreign currency position 19 18 18 18" (2000, 2005, 2009, 2010 respectively).
- Implication: "At end-2010, Croatian economy’s large negative net external financial balance is mostly due to its corporate sector."

### Conclusion (selected points)
- Key vulnerabilities stem from: "a high external debt stock, large financing needs and limited reserves" combined with "a highly-euroized domestic financial sector."
- Recovery prerequisites: "improving competitiveness, maintaining market confidence, and reducing vulnerabilities, which would require a multi-faceted macroeconomic and structural policy response."
- Policy priorities summarized:
  - Expenditure-based fiscal consolidation aiming for a cyclically-adjusted balanced budget.
  - Strengthened public debt management covering guarantees and increasing domestic-currency financing.
  - Continued reserve accumulation supported by export-led improvements through structural reforms and competitive wage policy.
  - Maintain strong bank capital and liquidity buffers and prudent regulation to contain currency and contagion risks.

*International Monetary Fund, Republic of Croatia, Selected Issues, Prepared by Jesmin Rahman (EUR), Approved by the European Department, June 8, 2011.*

### 14.      Croatia’s private corporate sector is highly leveraged. Overall net indebtedness

### 14.      Croatia’s private corporate sector is highly leveraged. Overall net indebtedness

### Corporate sector leverage and vulnerabilities
- Overall net indebtedness has continued to increase during the crisis and reached over 70 percent of GDP by end-2010.
- Roll-over pressures remain low given the mostly long-term nature of the debt.
- High level of net foreign currency indebtedness exposes the corporate sector to exchange rate risks.
- Corporate exposure to currency risk has grown as new currency-indexed loans have largely been granted to corporates in the non-tradable sector.
- Certain sectors have especially high currency risk: real estate and construction, transport, communication, hotel and restaurants — where the share of foreign currency denominated or linked debt is as high as 90 percent.
- Interest rate risk: around 95 percent of total lending to corporates carries an interest rate that is variable within a year.

### Household indebtedness and vulnerabilities
- Gross household indebtedness is high: 41 percent of GDP and 85 percent of disposable income.
- Households spend nearly 7 percent of their disposable income on interest payments.
- Large foreign-currency debt: about 70 percent of household debt is in foreign currency.
- Interest rate structure: 96 percent of all household loans are issued with interest rate variable within a year.
- Macroeconomic implications: High household indebtedness and ensuing deleveraging, together with sluggish labor market conditions, pose a drag on consumption and economic recovery.

### Macroeconomic consequences and assessment (Conclusion, VI)
- Large balance sheet vulnerabilities across sectors compromise Croatia’s ability to counter macroeconomic shocks and have weighed down its growth prospects.
- Croatia weathered the most recent crisis due to strong pre-crisis prudential policies and parent banks’ willingness to keep or increase exposures, but the economy’s capacity to tackle another major macroeconomic or financial shock is limited.
- Large balance sheet vulnerabilities constrain exchange rate policy options and, together with pervasive structural rigidities and a lack of fiscal policy space, diminish the economy’s ability to withstand shocks.
- While the worst of the recession is behind, resuming sustainable growth in the medium term remains a challenge:
  - A small export sector is not providing the needed pull for growth.
  - Households are deleveraging.
  - Any downturn in investor sentiment could trigger corporate sector deleveraging, prolonging the recovery.

### Policy recommendations (orderly unwinding of vulnerabilities)
- Given the stable exchange rate policy, a consistent set of structural, fiscal, monetary and prudential policies are needed for sustained growth and reduced vulnerabilities.
- Reducing external indebtedness of the economy requires policies that enhance competitiveness and growth potential, and lower reliance on debt-financed and domestic absorption-driven growth. This requires:
  - Corrective wage and structural policies that would increase tradable sector’s contribution to growth.
  - Policies to enhance economy-wide productivity.
  - Measures to allow financing of external current account deficits through higher non-debt creating flows (FDI).
- Reducing public sector indebtedness requires reduction of public expenditures to achieve a cyclically-adjusted balanced budget in the medium term.
  - Care should be given to potential crowding out concerns and currency risks as authorities pursue greater reliance on domestic financing.
  - Pursuit of policies to increase the share of domestic currency finance would be appropriate.
- Croatia should continue to build up reserves to enhance its ability to absorb shocks.
  - Large prudential foreign currency buffers should be maintained to safeguard the stability of the highly-euroized financial sector.

*Source: IMF staff report excerpt (Tables and numeric data in original). *

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11160.pdf_