Results of in-depth reviews under Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances

Croatia is experiencing excessive macroeconomic imbalances, which require specific monitoring and strong policy action. In particular, policy action is required in view of the vulnerabilities arising from sizeable external liabilities, declining export performance, highly leveraged firms and fast-increasing general government debt, all within a context of low growth and poor adjustment capacity. The Commission will put in motion a specific monitoring of policy implementation, and will regularly report to the Council.

More specifically, after an expansionary phase, in which imbalances accumulated, Croatia is now experiencing a prolonged bust, in which a range of external and internal risks have come to the fore. External rebalancing is beset by important risks pending the reduction of Croatia's foreign liabilities to safer levels and is conditioned on improved competitiveness and broadening exports beyond tourism to support growth. The deleveraging of non-financial corporates is still at an early stage and non-performing loan developments in this segment need monitoring. State-owned enterprises, which in some sectors still play a dominant role and which are often un-restructured, are overall highly indebted and weakly profitable. Croatia has the lowest activity and employment rates in the EU, which is partly related to underlying institutions and policy settings. Better labour market functioning will be crucial to support the growth and adjustment needed in view of external and internal vulnerabilities. On nearly a range of standard indicators, Croatia's business environment ranks significantly below the average for central and eastern European Member States. These factors combine to lower potential growth, which hinders private sector balance sheet repair and increases the required fiscal consolidation effort. There is a need for significant additional fiscal consolidation efforts to curtail the deficit and prevent debt from rising unsustainably. Croatia is in EDP and needs to take effective action to address the excessive deficit by 30 April 2014. On current trends, in the absence of additional measures, Croatia risks missing its targets by a large margin in 2014.

Excerpt of country-specific findings on Croatia, COM(2014) 150 final, 5.3.2014

Executive Summary and Conclusions 7

1. Introduction 11

2. Macroeconomic Developments 13

3. Imbalances and Risks 19

3.1. EXTERNAL SECTOR ANALYSIS AND COMPETITIVENESS ISSUES 19

3.1.1. External sector trends 19

3.1.2. External Competitiveness 22

3.2. INDEBTEDNESS AND DELEVERAGING DYNAMICS 34

3.2.1. Private sector indebtedness 35

3.2.2. Public indebtedness 41

3.3. MONETARY AND FINANCIAL SECTOR ISSUES 48

3.3.1. Macro-prudential policy in Croatia in the run-up to the crisis 49

3.3.2. Monetary and exchange rate issues 50

3.3.3. The situation of the banking sector 52

4. Policy Challenges 61

References 63

LIST OF Tables

2.1. Key economic, financial and social indicators - Croatia 18

3.1. Structure of the Croatian banking system 53

3.2. Capital and loan loss provisions analysis 57

LIST OF Graphs

2.1. GDP dynamics and contributions 13

2.2. CPI inflation 14

2.3. Selected labour market indicators 14

2.4. 5-year CDS USD 16

2.5. Current account and components 16

2.6. Gross external debt 17

3.1. Current account composition 19

3.2. Exports and Imports 19

3.3. Current account financing 20

3.4. Net IIP 20

3.5. Current account adjustment in selected Member States 20

3.6. Decomposition of rate of change of NIIP 21

3.7. Gross IIP - liability-side breakdown % of total 21

3.8. Gross external debt per sector 21

3.9. Export market share decomposition 22

3.10. Volume of exports of goods and services 22

3.11. Trade openness 23

3.12. Value of exports of travel services 23

3.13. Compensation and productivity 26

3.14. Nominal ULC 26

3.15. Adjusted wage share 27

3.16. ULC-deflated REER 27

3.17. REER deflated for nominal wage costs in manufacturing 27

3.18. Doing business 2014, country ranking 30

3.19. Economic freedom 2014 index, country ranking 31

3.20. Global competitiveness 2013-14 index, country ranking 31

3.21. FDI inflows 32

3.22. FDI inflows per sectors, % of total 32

3.23. Sectoral structure of inward FDI stock 33

3.24. Debt by sector, non-consolidated 34

3.25. Private sector debt 35

3.26. Decomposition changes in debt-to-GDP ratio, households 36

3.27. Decomposition changes in debt-to-GDP ratio, NFC 36

3.28. NFC leverage indicators 36

3.29. Household leverage - Croatia and CEE10 40

3.30. NFC leverage - Croatia and CEE10 40

3.31. Credit institutions' claims 41

3.32. Consolidated central government 44

3.33. General government balance 44

3.34. Structural government balance 44

3.35. General government debt 44

3.36. Contingent state liabilities 45

3.37. T-bills auctions, average yields 46

3.38. Kuna exchange rate 51

3.39. Croatia - Real and nominal effective exchange rates (42 countries; monthly data) 51

3.40. NPLs and coverage ratio, Q3 2013 53

3.41. Key financial indicators 53

3.42. Corporate debt evolution 54

3.43. Banking and leasing assets 54

3.44. Loans and deposits 55

3.45. Property price index 60

LIST OF Boxes

3.1. Croatia’s declining goods exports 25

3.2. Employment protection legislation as impediment to competitiveness 30

3.3. Financial Performance of Firms, including SOEs 38

3.4. Pre-bankruptcy settlement legislation 43

3.5. Public debt sustainability analysis 47

3.6. Banks’ exposure to the general government and SOEs 58

LIST OF Maps

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EXECUTIVE SUMMARY

In the Alert Mechanism Report (AMR) published on 13 November 2013, the Commission found it useful to investigate the nature of and potential risks related to Croatia's external position, trade performance and competitiveness, as well as internal developments. To this end this In-Depth Review (IDR) provides an economic analysis of the country's macroeconomic and structural situation in line with the scope of the surveillance under the Macroeconomic Imbalance Procedure (MIP), with a view to understanding whether imbalances exist. Croatia joined the EU on 1 July 2013 and this is its first IDR. The main observations and findings of this analysis are:

· After an expansionary phase up to 2009, in which imbalances accumulated, Croatia is now experiencing a deep and prolonged downturn, in which a range of external and internal risks have come to the fore. Delayed restructuring of the manufacturing sector and an inability to establish sizeable, competitive export industries beyond tourism limited Croatia's participation in regional trade integration during the boom years as a result of which it has remained one of the least open of the smaller EU member states with low relative income levels. A widening current account deficit was largely funded by the foreign parents of Croatian banks and by Foreign Direct Investment (FDI) into inward-oriented sectors of the Croatian economy. As the global financial crisis unfolded, capital inflows suddenly stopped in 2009. The impact on Croatia was severe: domestic demand rapidly contracted and the ensuing recession led to soaring unemployment. The country entered a long-drawn recession from which it has not yet recovered. Despite the reversal in the current account, vulnerabilities such as high external liabilities, uncompetitive exports, a corporate debt overhang and growing public sector indebtedness persist. Structural weaknesses have contributed to these imbalances, including a poor business environment and a malfunctioning labour market. State-owned enterprises still play a dominant role and are often highly indebted and weakly profitable. These factors also combine to lower potential growth, which hinders private sector balance sheet repair and increases the required fiscal consolidation effort.

· External rebalancing is beset by important risks pending the reduction of Croatia's high foreign liabilities. Domestic economic weakness reduces the affordability of foreign liabilities and limits the appeal of Croatia to lenders and existing investors in inward-oriented industries. The recession therefore increases Croatia's vulnerability to capital flow reversals. For 2014 public and private sector external re-financing needs are in excess of 20% of GDP. The high share of FDI in overall liabilities does reduce volatility to an extent, although it comprises a substantial portion of intra-company loans. Dramatically lowered import volumes have closed the current account, but the small surpluses forecast for 2014 and 2015 will not suffice to bring the negative net international investment position to a safer level.

· Croatia's low competitiveness had been eroding export market shares even before the crisis. Croatia has been and remains a comparatively expensive production location. After 2004, Croatia's export market shares started falling from their already low level. These losses have accelerated since the crisis, indicating the persistence of a substantial competitiveness gap. Export market share losses have been concentrated in goods exports, where labour cost levels stand out in regional comparison, whereas overall labour costs have grown moderately since 2009 in comparison with competitors. High costs combine with a wide range of non-cost-competitiveness deficiencies. One-off factors, including the restructuring of the shipbuilding and chemicals industries, have interacted with low overall competitiveness to generate a decline in goods exports in 2013.

· Weaknesses in the labour market and in the wider business environment have amplified the impact of the crisis and prevent adjustment towards stronger, more sustainable growth and employment. The employment rate in Croatia was consistently low throughout the past decade and, from 2010, has been the lowest out of the (now) EU28 countries. The protracted recession has pushed the unemployment rate above 17% in 2013, a twofold increase since 2008, with young people and low-skilled workers particularly affected. Beyond cyclical developments, these dismal labour market outcomes are also partly related to aspects of underlying institutions and policy settings. The social protection system provides multiple avenues for early withdrawal from and discourages participation in the labour market. Obstacles in the business environment include a high regulatory burden, inefficiencies in the administration of construction permits and property registration, prolonged litigation and bankruptcy procedures, weak protection of investments, and high policy uncertainty.

· The non-financial private sector, and in particular non-financial corporations, entered the crisis highly leveraged as a result of rapid credit growth in the preceding years. Countercyclical monetary policy loosening and buffers in the financial system initially absorbed some of the shock. This deferred the onset of contractionary credit retrenchment and balance sheet repair in the non-financial corporate sector. But the high level of euroisation has limited the central bank's room for manoeuvre. Deleveraging pressures began to grow as of 2011 but refinancing by banks and foreign parent companies has on the whole remained available and the reduction in corporate sector indebtedness is proceeding at a rather slow pace. Many state-owned enterprises, in particular, appear to have comparatively high debt levels, especially in view of their overall weak profitability. Household balance sheets are also under pressure, notably as a result of labour market developments, but the sector's lower level of indebtedness limits vulnerabilities.

· The largely foreign-owned banking system has shown resilience. Previous macro-prudential measures helped to ensure that banks built significant capital and liquidity buffers, and both of these proved useful during the crisis. Still, the weak economy has started to interact with the banking sector, and non-performing loans (NPLs) to corporate borrowers have risen to high levels. Despite some recent signs of stabilisation, these developments will need to be closely monitored. The persistent weakness in the economy has also led to a reduced demand for credit from the private sector, and banks have compensated by increasing lending to public entities. A continuation of these trends would be problematic, however, in light of the high level of indebtedness of several SOEs.

· Loose fiscal policies in the downturn have exerted sustained pressure on the general government deficit and debt. The general government deficit averaged 6% of GDP in 2009-2013. Deficit trends and sizeable negative stock-flow adjustments have caused a sharp deterioration of Croatia’s general government debt ratio, which had been comparable to those of regional peers before the crisis but has risen sharply to reach 64.9% of GDP at the end of 2013. Commission projections and sensitivity analysis indicate the need for significant additional consolidation efforts to curtail the deficit and prevent debt from rising unsustainably. The high foreign currency share and the relatively short average maturity of the debt, together with contingent fiscal liabilities arising in troubled state-owned enterprises, add to sovereign financing vulnerabilities.

The IDR also discusses the policy challenges stemming from these imbalances and what could be possible avenues for the way forward. A number of elements could be considered:

· Greater sustainability of Croatia's external position is conditioned on improved cost and non-cost competitiveness and broadening exports beyond tourism. This would be instrumental to attract substantial, high quality FDI and regenerate Croatia's industrial fabric to support rebalancing and lay the foundations for sustainable growth and the creation of jobs. These objectives can be further supported by efficient leverage of European Structural and Cohesion funds. In view of the high external liabilities, and the extent of foreign-currency denominated obligations of the financial, non-financial and public sectors, the maintenance of strong, stability-oriented macroeconomic policies is a strategic imperative.

· The low activity and employment rates and the scale of the labour market adjustment arising from the decline of Croatia's manufacturing industries represent a major policy challenge. A comprehensive response could involve carefully reconsidering, and, where necessary, adjusting a number of institutions and policies affecting labour market functioning. Building on reforms recently undertaken, there could be further scope to reduce inactivity traps, to make employment protection less onerous for businesses and to enhance the effectiveness and reach of Active Labour Market Policies. In view of the multiple and wide-ranging business environment challenges that hinder adjustment and constitute a barrier to investment and exports, there is scope for concerted improvements.

· In view of private sector over-indebtedness, it would be important to ensure the necessary conditions for a smooth continuation of the deleveraging process, including through proper functioning of insolvency and debt-restructuring regimes. Correctly functioning financial intermediation is also important, notably to ensure that credit is correctly allocated within the economy as deleveraging continues. It may be useful to monitor the increase in bank lending to SOEs.

· Close monitoring and supervision of systemic banks will continue to be important, in cooperation with home country supervisors. In this respect, the ongoing ECB comprehensive assessment exercise will include the four largest Croatian banks, through their respective parents. There is scope to consider complementing this with additional supervisory diagnostic steps from a Croatian perspective.

· There is a pressing need for high-quality, structural fiscal consolidation measures. Compliance with the targets contained in the excessive deficit procedure opened on 28 January, 2014 and thereafter with the requirements of the SGP would ensure that Croatia's debt is on the sustainable path. A number of supporting polices can be considered, including tax shifting towards less mobile factors, substantial reductions in subsidies to firms, and improved targeting of and administration of social benefits. Credible fiscal policy supported by fiscal institutions and rules, at all levels of government, will support sustained deficit and debt reductions.

On 13 November 2013, the European Commission presented its third Alert Mechanism Report (AMR), prepared in accordance with Article 3 of Regulation (EU) No. 1176/2011 on the prevention and correction of macroeconomic imbalances. The AMR serves as an initial screening device helping to identify Member States that warrant further in-depth analysis to determine whether imbalances exist or risk emerging. According to Article 5 of Regulation No. 1176/2011, these country-specific “in-depth reviews” (IDR) should examine the nature, origin and severity of macroeconomic developments in the Member State concerned, which constitute, or could lead to, imbalances. On the basis of this analysis, the Commission will establish whether it considers that an imbalance exists in the sense of the legislation and what type of follow-up in terms it will recommend to the Council.

The AMR suggested the need to look more closely at whether Croatia is exhibiting macroeconomic imbalances of an external and internal nature, in the context of a contracting economy. On the external side, the AMR highlighted the high negative net international investment position and poor export performance, reflecting unfavourable product specialisation and geographic orientation. On the internal side, the AMR highlighted high private sector debt, increasing non-performing loans, deleveraging pressures, rising public debt and contingent fiscal liabilities, and weaknesses in the business environment, domestic competition and labour market. To this end this IDR provides an analysis of the Croatian economy in line with the scope of the surveillance under the Macroeconomic Imbalance Procedure (MIP).

Against this background, Section 2 first provides an overview the general macroeconomic developments, Section 3 looks more in detail into the main imbalances and risks. Section 4 discusses policy considerations.

Real economy and price developments

Croatia has been mired in recession since 2009. Five years of contraction have reduced Croatia's real GDP by nearly 12% and only a muted recovery is forecast for the coming two years. The 2008 global financial crisis brought to the surface deep-rooted structural problems, including uncompetitive export industries, a significant private debt overhang, a weak labour market and poor governance of public finances. These factors, which are accentuated by the unsupportive external environment, make economic adjustment slower and more costly and have thereby lengthened and deepened the recession. The obstacles to stronger, more sustainable growth are still firmly in place.

The decline in real GDP since 2008 is attributable to a sharp contraction in domestic demand, chiefly investment (Graph 2.1). From a peak of 28% of GDP in 2008, investments have plummeted to 19%, a real decline entailing a particularly steep contraction of construction activity. Household consumption was hit by the rapidly deteriorating labour market, in combination with declining disposable income, worsening consumer sentiment and tighter bank lending conditions. Net trade made a positive contribution to GDP for most of the period as depressed household and corporate demand caused imports to contract more than exports. Low and declining labour utilisation (the lowest activity rate in the EU) and major disinvestment have dragged potential growth into negative territory.

Recent GDP developments underline the weakness of the economy. Real GDP declined by 0.9% year-on-year in the first three quarters of 2013 following a 2% contraction a year earlier. Falling exports turned the contribution of net exports to growth negative amid continued subdued external demand, the on-going restructuring of the once important shipbuilding sector and trade diversion following the exit from the Central European Free Trade Agreement (CEFTA) area. Domestic demand continued to contract in 2013, but there were signs of a subdued rebound, possibly supported by positive impacts on household consumption and investment activity from EU entry.

Medium-term prospects are slightly more favourable. A gradually improving external environment and access to significant European Structural and Cohesion Funds have the potential to lift economic activity.([1]) The magnitude of this impulse will depend on the ability of the authorities to effectively address some of the long-standing structural bottlenecks to growth. According to the Commission Winter 2014 forecast (WF2014), real GDP growth of 0.5% in 2014 is set to be followed by a slight acceleration to 1.2% in 2015. The main risk to the country’s short-term growth profile stems from the need for significant fiscal adjustment to avoid unsustainable debt trajectories and restore credibility.

CPI inflation moderated significantly in the course of 2013. This reflected weak demand that more than offset increases of indirect taxes and regulated prices. The average annual inflation slowed down to 2.2% in 2013 from 3.4% a year earlier, and is set to further decline in 2014, according to the WF2014 (Graph 2.2) in the absence of demand-side pressures despite new indirect tax increases. ([2]) Core inflation has

stabilised at around 2% in the last few years, but has also started easing from the second half of 2013.

Labour market developments

Protracted recession has hit the labour market, pushing the unemployment rate above 17% in 2013, a twofold increase since 2008 (Graph 2.3). Hiring in the already large public sector and the slow process of restructuring of troubled state-owned companies averted an even steeper rise in joblessness. Cyclical developments have compounded long-existing structural deficiencies that are reflected in one of the lowest employment rates in the now EU 28 throughout the past decade. These structural elements include legislation that dampens job creation by raising implicit labour costs. The social protection system may also lead to inactivity traps and discourage labour market participation. At the same time, the high levels and long spells of long-term unemployment reduce the employability of the labour force even in times of rising activity, signalling skills gaps, hiring barriers or a combination of both. These impediments, if not addressed, risk impairing the transmission of future economic growth into job creation, keeping jobless rates elevated for longer and so accentuating labour market hysteresis.

The economic crisis has particularly affected young people and low-skilled workers. Youth unemployment (in the age group 19-24) has soared to around 50% in 2013, taking it to a scale that can have potentially lasting impacts on social cohesion. Structural features of the labour market lead to high fragmentation and significant hiring constraints, which disproportionately affect new entrants to the labour market. The increased use of fixed term contracts risks exacerbating labour market segmentation, particularly for young people. The unemployment rate among the low-skilled is also high, while the activity ratio in this segment remains low and on a declining trend, which is suggestive of skills mismatches. Budgets for youth employment promotion have been increased and some relevant measures have been implemented.

Rising unemployment is mirrored in worsening social indicators. The share of people at risk of poverty increased by 4 pp in four years, peaking at 21.3% in 2011. This is in contrast with the relative stability of this indicator in the EU, including Member States in Central and Eastern Europe, over the same period. Apart from the stronger worsening of the labour market situation in Croatia compared to the EU average, this divergence appears to be also the result of insufficient fiscal room for social policies to cushion the effect of the crisis. The social implications of job losses are also reflected in the high, and rising, share of people living in families with low work intensity (16.1% in 2012 versus 10.3% in the EU). Structural labour market challenges and the low participation rate thus affect both economic and social outcomes.

Public finances

The pro-cyclical fiscal policies of the boom years have been followed by relatively loose policies in the downturn, exerting sustained pressure on the general government deficit. Reform efforts to address structural weaknesses, mainly on the expenditure side, have remained timid. The debt level was increased by a further 4% of GDP in 2009-2011 by the assumption of obligations of state-owned companies, mostly related to activation of government credit guarantees that impact public finances negatively via the interest expenditure channel. These trends have contributed to more than double the nominal debt since the end of 2008, reaching 64.9% of GDP at the end of 2013.

After some consolidation measures in 2012, fiscal policy was loosened again in 2013. The government twice revised its cash-based deficit target in 2013, the second time in November by 2 percentage points of GDP. Manifestly overoptimistic macroeconomic projections underlying the budget combined with unexpected revenue shortages (in VAT collection ([3]) and corporate income tax collection) ([4]) as well as settlements of debt arrears in the healthcare sector ([5]) drove a substantial wedge between budget and outturns. The 2014 budget adopted in December 2013 does not reverse the public-finance trajectory. A revision is pending in the first quarter of the year to take into account the required fiscal adjustment in line with the recommendations issued by the Council in the context of the excessive deficit procedure on 28 January 2014.

Significant fiscal consolidation measures are required to safeguard the sustainability and stability of Croatia's public debt. According to the Commission's latest forecast, on current trends, in the absence of additional measures, Croatia would not be able to curb the upward public debt dynamics (see Box 3.5 in Section 3.2.) on debt sustainability analysis). High domestic bank liquidity, supported by the central bank's policies, is currently central to the uninterrupted financing of the rising needs of the state although the authorities have continued to tap international financial markets. Croatia placed two bonds on the US market in 2013, albeit at high, and rising, costs (Graph 2.4). ([6]) Apart from the steep growth in the public debt, contingent liabilities stemming from state guarantees for loans to public companies are also a cause of concern in view of their still elevated levels and the track record of activation in recent years.

External sector

The crisis has induced an abrupt swing from a current account deficit of close to 9% of GDP in 2008 to a surplus of around 1% of GDP in 2013 (Graph 2.5). Depressed household and investment demand caused imports to fall further than exports. The underlying merchandise export performance remained constrained by the unfavourable external environment, the low competitiveness of domestic goods and the restructuring of key export sectors (notably shipbuilding). After a sharp decline in 2009, exports of services, especially tourism, have recovered well, benefiting from positive global trends as well as diversion of tourist flows arising from political instability in North Africa and the Middle East.

On the financing side, net FDI declined sharply from 8.9% of GDP in 2008 to around 2.4% in 2012. The investment potential in the banking and real estate sectors has been largely exhausted and other sectors have not established investor-appeal, despite the accession to the EU, so a further decline was recorded in 2013. Worsening macroeconomic prospects, the poor business climate, restrictive labour legislation, and the high degree of policy uncertainty also deter investors.

Significant government borrowing counteracted bank and corporate deleveraging to maintain the country’s gross external debt above 100% of GDP (Graph 2.6). High external financing needs make the country vulnerable to external shocks and exchange rate risks. The latter seems to be mitigated by the central bank’s focus on maintaining a stable exchange rate against the euro and a stable international reserve stock, covering more than 8 months of (albeit cyclically low) imports at the end of 2013.

Financial sector

Problems in the real economy are denting banking sector performance. Depressed economic activity has translated into weak credit demand resulting in contracting credit to both households and corporates since mid-2012. Supply factors also played a role in the credit contraction, as lenders focused on limiting risks and cleaning rapidly deteriorating balance sheets, which may hinder investment in the real sector. The share of non-performing loans (NPLs) to the private sector stood at 15.6% at the end of 2013 chiefly due to NPLs in excess of 28% in the corporate segment. Households have also fallen behind in their debt-servicing, although at a more gradual pace. Households are particularly affected by unemployment trends and adverse exchange rate effects related to Swiss franc-denominated loans. Interest rates on such loans are subject to a cap from 2014. While these developments are intended to make repayments more affordable, they dent bank profitability and may distort incentives. Capital buffers nevertheless remain sufficient and the sector maintains and adequate level of liquidity. The central bank has macro-prudential policies in place to mitigate the build-up of new risks. The dominant foreign ownership of banks reduces potential contingent liabilities for the sovereign. Feedback loops with the real and fiscal sectors could, however, intensify, due to the banks' increasing holdings of government securities and lending to state-owned enterprises.

3.1. EXTERNAL SECTOR ANALYSIS AND COMPETITIVENESS ISSUES

Strong capital inflows up to the 2008 global financial crisis were to a large extent directed to and channelled through Croatia's banking sector. As in regional peer economies, these inflows were the driving force of Croatia's growth. However, the sizeable foreign direct investment (FDI) inflows largely by-passed the tradable sector. In fuelling domestic demand, capital inflows widened the current account deficit, contributing to the build-up of internal and external debt and price pressures. By 2008, Croatia had accrued gross external debt in excess of 100% of GDP but had invested only a small part in productive domestic assets and economic transformation. Consequently, the domestic economy is now in a period of forced balance sheet repair which weighs on growth (see Section 3.2.).

Subsection 3.1.1. presents the dynamics and the financing of the current account and the net international investment position (NIIP) and discusses external vulnerabilities. Subsection 3.1.2. explores the underlying export performance, which is very weak for merchandise, and examines the distinct roles of cost-competitiveness, the labour market, the business environment and FDI.

3.1.1. External sector trends

The expansionary phase

The converging Croatian economy ran sizeable current account deficits from 2000 to 2008. Consumption and investment exceeded domestic production and savings, resulting in an average current account deficit of 5.5% of GDP over the period. Surging investment pushed the deficit close to 9% of GDP in 2008 (see Graph 3.1). The negative trade balance, reflecting a strong deficit in goods trade, accounted for the bulk of the deficit. This was partially compensated by the surplus from trade in services arising from the large tourist sector (see Graph 3.2).

Large deficits were mainly financed by robust FDI inflows. Annual average net FDI amounted to nearly 5% of GDP in the period 2000-2008, covering approximately 90% of the current account deficit. Privatisations and follow-up investments by parent companies were key determinants of FDI (see Graph 3.3). Other investments, principally long-term loans to corporates and foreign banks’ deposits, were of a broadly equal magnitude to the FDI flows in the years preceding the crisis.

The economy's stock of foreign liabilities grew more than five-fold between 2000 and 2007. Private capital inflows, together with negative valuation effects due to rapidly growing asset prices, contributed to a surge in the NIIP from 17% of GDP at the end of 2001 to 93% at the end of 2007 (Graph 3.4). ([7]) These financing flows, while increasing gross external debt, also enabled significant accumulation of international reserves.

The prolonged downturn

From a deficit of 8.8% of GDP in 2008, the current account swung into a small surplus in 2013. Falling domestic demand through the long recession has caused an abrupt fall in imports. The drop in imports of capital goods was particularly pronounced, mirroring very weak investment activity amid corporate balance sheet repair (see also Section 3.2.). Goods exports fell in absolute terms over the period, but exports of services rebounded due to tourism, which benefited from diversion of tourist flows from North Africa and the Middle East. Despite the severity of the downturn in Croatia, the current account swing has been of an average magnitude for the region (Graph 3.5).

The downturn transformed the external financing of the economy. Annual average net FDI flows plummeted to 2% of GDP in the 2010-13 period, from around 6% of GDP between 1999 and 2008. An even stronger contraction was recorded in long-term borrowing reflecting on-going deleveraging by banks and corporates (see also Section 3.2.) ([8]). A change in the financing patterns of businesses, from foreign to domestic sources, was also evident. At the same time, portfolio investments increased as a result of foreign borrowing by the state.

The headline current account is expected to remain in surplus in the near future. Investment is set to remain subdued and household demand will be under pressure from negative labour market developments. At the same time, the gradually improving external outlook and potential efficiency gains as a result of the industrial restructuring taking place in the last few years in legacy industries such as shipbuilding and chemicals may stem the decline in exports.

Vulnerabilities

The closing of the current account has not improved Croatia’s external liability position. The NIIP is gently reducing from around 90% of GDP as the result of valuation changes and two opposing trends in transactions: a gradual reduction in the stock of corporate and banking sector liabilities and an increase in portfolio borrowing, in particular by the state (Graph 3.6). This relative stability belies significant refinancing pressures for banks and corporates and mounting refinancing risks for the state. Absent strong nominal GDP growth, which would accelerate private balance sheet repair, curtail sovereign borrowing needs and ease the external debt burden, current trends in transactions and valuations are not going to substantially reduce the NIIP.

The high stock of FDI mitigates Croatia's exposure to sudden reversals in financial flows. Direct investments accounted for 50% of foreign liabilities at the end of 2008 (see Graph 3.7 ). The share of direct investments held by non-residents has since slightly receded due to valuation effects. On the asset side, international reserves have been on an upward trend continuing through the recession period when private capital inflows abated. Sizeable assets accumulated in the non-banking financial sector, in particular in pension funds, are set to play an increasing role in NIIP developments.

However, the high level of gross external debt requires close monitoring. Reduced external exposure of financial institutions and public companies has brought gross external debt slightly below the 2011 peak level of 105% of GDP (see Graph 3.8 ). ([9]) These trends would have brought about a steeper decline, were it not for rising foreign borrowing by the sovereign and increasing cross-border, inter-company lending. Since the start of the crisis, the share of public external debt rose by 7 percentage points to reach 34% of total external debt at the end of October 2013. A commensurate drop was recorded in the share of private foreign debt (excluding inter-company lending) in line with the gradual deleveraging.

High external repayment needs remain an important vulnerability. Projected gross external debt repayments for 2014 exceed 20% of GDP, predominantly falling on the private sector. Intercompany loans and financing from parent banks, i.e. two types of debt that are usually more easily re-financeable, account for a considerable portion of due debt for corporates and banks (close to 12% of GDP). Nevertheless, a worsening in external financing conditions such as the emergence of liquidity constraints or a rise in borrowing costs, for instance through changes in risk premia, could affect refinancing possibilities. As for the sovereign, 2014 foreign debt re-financing needs have been covered to some extent, although at high borrowing costs, thus contributing to a steep increase of the interest payment bill and a deterioration of the fiscal position.

3.1.2. External Competitiveness

Export performance

The sudden halt of private capital inflows with the 2008 global financial crisis brought to the surface Croatia’s weak competitiveness. High investment (and borrowing) rates before the crisis, including significant FDI, did not result in strong export performance. Croatia has been losing export market shares since 2004 and there was has been a particular intensification in these losses since 2008 (see Graph 3.9, note the large relative increases in the first years start from a very low base). Greater sustainability of Croatia's external position is conditioned on improved competitiveness and ability to export.

Croatia's export performance lags significantly behind that of its peers. All new Member States from Central and Eastern Europe (CEE10) register higher export growth and latterly even the more mature euro area economy is outstripping Croatia (Graph 3.10). ([10]) The divergence in trade performance becomes particularly visible in the post-2008 period. While exports of the CEE10 (with the exception of Slovenia) managed to recover strongly from the one-off slump in 2009, Croatia’s volume of exports was 10% below its 2008 peak level in 2012.

Weak goods exports are central to Croatia's poor overall export performance. This is evident from Graph 3.10 above and examined in greater detail in Box 3.1. In the last 13 years, goods exports have remained stable at 22% of GDP. This is in marked contrast with the expansion recorded in CEE10 (from 46% of GDP in 2000 to 62% of GDP in 2012). Goods account for around half of Croatia's exports, with sizeable shares for machinery, electrical, chemical and mineral products.

One-off factors explain some of the more recent declines. As described in Box 3.1, specific industries as well as some export markets account for the bulk of the most recent declines. The shipbuilding sector, Croatia’s once leading export industry, is currently in restructuring. The exit from the CEFTA area implies reduced access to some regional markets, in particular Bosnia and Herzegovina, Croatia's second largest export market and one in which Croatian producers enjoyed competitive advantages. ([11])The tourism sector has shown some resilience but this has not sufficed to stem the decline in overall exports. Tourism already accounts for a third of Croatia's exports (and two thirds of services exports). ([12]) Services exports, led by tourism, fared better than goods exports over the past 13 years period (see Graph 3.12), but also underperformed when compared with new Member States, especially during the post-boom cycle.

Growth in tourism will become challenging to maintain in the longer term. Substantial development beyond summer tourism could only be pursued with significant investment. The absence of seasonal complementarities with other industries causes significant volatility in the labour market. To lengthen the season and attract higher-spending tourists, the sector's competitiveness would also need to be improved across several dimensions (see Heatmap), a process that realistically can only be achieved with sustained effort over long periods. Regional peers with similar natural endowments have not always succeeded in maintaining external sustainability after early success in the tourism market.

Heatmap: Tourism Ratings Across Five Dimensions of Competitiveness

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Box (continued)

Underlying competitiveness position

Croatia has been, and remains, a comparatively expensive production location. Croatian labour costs already exceeded those of most regional competitors in 2000. Along with Slovenia, Croatia has sustained relative labour cost levels that more than proportionately reflected higher labour productivity (Graph 3.13).

Nominal unit labour costs (ULC) have evolved moderately, albeit from a high starting point. Since 2000, wage and productivity developments have yielded ULC growth slightly higher than in the euro area, but lower than in the faster-growing competitors in Central and Eastern Europe (Graph 3.14). ([13])

Overall, Croatia's uncompetitive positioning has remained largely unimproved. Nominal ULC and productivity developments have resulted in a declining wage share in both Croatia and the CEE10 (see Graph 3.15). The wage share in Croatia remains rather close to that of the euro area overall, whereas its industrial structure differs markedly and its level of human capital and human capital utilisation is lower.

The damage to cost-competitiveness seems to have been most pronounced in the manufacturing sector (Graph 3.17). There was a steep worsening of the real effective exchange rate (REER) based on ULC dynamics in manufacturing. This contrasts sharply with the usual pattern of declining manufacturing ULC observed in competing economies, where productivity gains play a role, and in fast-adjusting economies. Relatively high labour cost and low productivity levels may account for some of the poor goods export performance detailed above and in Box 3.1.

There are signs that cost adjustment is beginning to take place. Over time, these reductions may facilitate the reorientation of the economy towards external demand. However, export market share losses have been gathering pace even since the turnaround in cost-competitiveness trends. This may reflect the degree of remaining cost misalignment and may also indicate impacts from additional, non-cost-competitiveness factors.

The role of the labour market

Croatia has recorded the lowest employment rates in the EU since 2010. Even during the expansionary phase of the cycle, the employment rate (for age 15-64) never exceeded 58% and was always one of the four lowest among the (now) EU28; by 2012 the employment rate had fallen to 52.4%. Unemployment rates dipped into single digits only briefly during the boom years. Lack of competitiveness constrained hiring in export-oriented industries, typically an engine of job creation in the region. Unsurprisingly, the large employment gap widened further during the recession. In addition to the social consequences, low employment impinges on fiscal sustainability and, through potential output, on overall external sustainability.

The large public sector has exerted upward pressure in economy-wide wage levels. There were significant increases in the wages of public sector employees between 2007 and 2009. Compensation in the sector was additionally raised by significant increases in bonuses and other payments, which were partly reversed in mid-2009, when the authorities scrapped a 6% increase in wages in the public administration that had been introduced at the beginning of the year. This was followed in 2013 by a 3% cut in the public wage bill. In the business economy, labour costs have followed the economic cycle somewhat more closely, declining from 35% of the EU average in 2008 to reach 30% in 2012. ([14])

Significant jobs losses have been recorded in sectors exposed to actual or potential competition from abroad. Whereas job destruction was largely the consequence of the downsizing of some non-tradable sectors to more sustainable levels (e.g. construction), sharp job losses were also recorded in manufacturing. This indicates clear weaknesses in sectors that are or could potentially be in competition with abroad and adds to the challenges of fostering a more competitive economy.

The institutions underpinning labour market performance exhibit a number of shortcomings. The social protection system favours and provides multiple avenues for early withdrawal from the labour market and discourages labour market participation in the low-wage sector by putting a high floor under the reservation wages of certain categories of beneficiaries. Unemployment benefit replacement rates for are low, especially after 3 months, and duration is not very long. However, transitions into work, even into low-paid work, may still be disincentivised as a result of the immediate discontinuation of social assistance above low earned-income thresholds. ([15]) Adjustment difficulties, skills gaps and mismatches in the labour market stand out as major bottlenecks. Current employment protection legislation, although not very stringent in EU comparison ([16]), may nevertheless hinder job creation, given Croatia's current stage of development and mounting adjustment needs (see Box 3.2.) although this may be addressed by on-going reform efforts. Furthermore, the de jure flexibility of employment legislation can be undermined by legal uncertainty and court delays. Finally, low recorded employment may also reflect a sizeable grey economy ([17]), which is also a feature of neighbouring countries and of economies dominated by seasonal work.

The role of the business environment and product markets

Croatia's business environment is marked by multiple shortcomings that may dent its cost and non-cost competitiveness as well as the performance of the domestically-oriented economy. Among these, a high regulatory burden, inefficiencies in the administration of construction permits and property registration, poor justice system functioning, prolonged litigation and bankruptcy procedures ([18]), weak protection of investments, high policy uncertainty ([19]), weak corporate governance, insufficient know-how in marketing local produce stand out as significant bottlenecks. ([20]) Several surveys place the country amongst the worst EU performers in terms of business climate and competitiveness (see Graphs 3.18-3.20). While structural features such as these tend to exhibit significant persistence, they may interact with investment, particularly FDI, to explain worsening export performance.

Several of the areas in which Croatia underperforms the CEE10 are directly relevant to potential investors searching for a production location. This can be illustrated taking five of the Doing Business indicators where Croatia scores poorly. The ease of trading across borders is important for potential exporters; Croatia's poor score is particularly attributable to the cost of procedures required in order to ship goods (amounting to USD 1,335 to ship a notional container which compares to USD 1,070 on average in the OECD). Registering property and obtaining construction permits are important for potential greenfield investors; Croatia's poor scores on these indicators largely stem from lengthy procedures, with registration taking 102 days for a notional warehouse project (versus 24 days on average in the OECD) and permits taking 317 days (141 days in the OECD). Finally, investors (including local investors) need to be well protected by the law and here Croatia's poor score is largely attributable to directors' limited disclosure requirements and obstacles to shareholders seeking redress. Barriers to FDI are also generally barriers to local entrepreneurship, investment, business start-ups and job creation.

The civil justice system is accumulating backlogs. The length of judicial proceedings in litigious civil and commercial cases remained among the highest in the EU, although it was slightly shortened from 462 days in 2010 to 457 day in 2012 (Disposition Time, CEPEJ data). Despite the fact that the courts in 2012 resolved 16% more litigious civil and commercial cases compared to 2010, the rising number of incoming cases and the reduced clearance rate of 95% contributed to the rise in backlog. Until the end of 2012, the number of litigious civil and commercial pending cases rose by 15% compared to 2010, and remained among the highest in the EU (measured per capita). Legislative amendments upgrading the role of the financial agency FINA appear to have improved the effectiveness of enforcement on monetary assets, although the effectiveness as regards other types of assets remains a challenge (e.g. immovable property where the recovery rate appears to be low). The length of proceedings in land registry cases was reduced from 50 days in 2010 to 42 days in 2012 (Disposition Time, CEPEJ data). Compared to 2010, the falling number of incoming land registry cases and the Clearance Rate of 101% resulted in a reduction of the number of pending cases by 20% by the end of 2012. Preliminary data indicate that the number of incoming insolvency cases in 2012 rose significantly, compared to 2010. Legal certainty and effective processing is important for investment and adjustment. This is the case not just for commercial cases, including insolvency, but also labour cases, where court delays and/or legal uncertainty can theoretically result in stronger job protection de facto than de jure. These results are consistent with Croatia's poor score on the resolving insolvency indicator of the World Bank's Doing Business Survey 2014, which finds procedures take 3.1 years to conclude (versus 1.7 years on average in the OECD) and that the recovery rate is around 30% (vs. 70% in the OECD).

Structural product market weaknesses have also been present. The transport, utilities and postal services were shielded from competitive pressures during the cyclical upturn. This protection came at the price of weaker efficiency and raised costs for the economy. Increasing competition, in particular in electricity distribution, is likely to lower producer costs in the economy over the medium term.

The role of FDI

Croatia has missed out on the FDI flows that have transformed the export sectors of more successful peer economies. As detailed in Subsection 3.1.1., sizeable capital inflows comprising a high share of FDI led to the accumulation of a significant FDI stock in the 2000-2008 period. These inflows were comparable in magnitude to those of regional peers (Graph 3.21). However, the bulk of FDI was directed to the non-tradable sector, with financial intermediation and real estate activities and construction taking the lead. Countries such as the Czech Republic, Romania and Slovakia were able to attract a greater share of inward FDI into manufacturing (see Graph 3.22). Inward-looking investments in telecommunication and retail trade also featured prominently. Export-oriented sectors, on the other hand, attracted a small share of the huge investment flows in the period, resulting in a markedly different sectoral FDI structure compared to some of the CEE10 by 2012 (Graph 3.23).

Low FDI in export-oriented sectors reflects the full range of cost and non-cost-competitiveness shortcomings of the Croatian economy. In the labour-intensive export-oriented sectors, wage levels, taxation issues, labour regulatory issues and skills gaps are also likely to have deterred potential investors in the region. As a result of low FDI into export industries, Croatia missed opportunities to integrate into global supply chains and did not benefit from positive technological, governance and financial externalities associated with export-oriented FDI that ultimately lead to competitiveness gains and support economic growth. ([21])

FDI flows have dried up with the economic crisis and the remaining trickle still does not reach export-oriented sectors. Overall FDI went down sharply. This is partly a result of weak investment activity in Croatia's traditional EU investor base. ([22]) Competition between locations seeking to attract FDI has also intensified in the current low investment conjuncture. In this respect Croatia's worsened economic prospects and slow progress with the structural reform agenda are major drawbacks. The real estate and construction sectors have continued to receive FDI as on-going projects were completed and foreign retail chains continued to expand on the Croatian market.

Conclusion

Substantial liabilities coupled with major adjustment challenges leave Croatia with external vulnerabilities. This section has detailed the accumulation of the net international investment position and gross external debt. While the current account has now closed, the adjustment process is set to be lengthy. A range of elements in the labour market, in the business environment and in FDI trends have inhibited the growth and export performance that might speed the adjustment.

The Croatian manufacturing sector is in urgent need of renewal and FDI is the principal means by which this could be achieved. This section has highlighted the sharp deterioration in Croatia's goods exports performance, largely due to the near-collapse of certain industries. The manufacturing sector failed to capitalise on plentiful FDI in the boom years. The economic crisis and the withdrawal of subsidies have exposed these industries as uncompetitive in cost and non-cost terms. The sustainability and stability of Croatia's external position will depend on the regeneration of a manufacturing sector and other potentially-exporting sectors to complement tourism revenues. Until this is achieved, Croatia with its high foreign liability stock will remain vulnerable to currency movements and shifts in investor sentiment. An FDI facilitated structural shift into tradable sectors and economic integration into the EU would represent a break with the past borrow-to-consume model and set the foundations for more sustainable growth.

3.2. INDEBTEDNESS AND DELEVERAGING DYNAMICS

Rapid credit expansion, strong domestic activity and investor optimism were mutually reinforcing in the period to the 2008 crisis. On the supply side, credit growth was funded by sizeable foreign capital flows, driven by high global liquidity and strong investor appetite for emerging markets rather than by country-specific factors. These flows were partly channelled through the largely foreign-owned banking sector. Strong economic expansion went hand in hand with a steep accumulation of debt by the private sector, although from a relatively low level (Graph 3.24). ([23]) Both households and non-financial corporations more than doubled their debt levels as a share of GDP in the period 2001-2008. The significant tax bias towards debt-financed investment also skewed firms' financing choices, contributing to corporate indebtedness. ([24]) The state was able to reduce its outstanding liabilities gradually over the period due to favourable economic trends. At the same time, however, the state accumulated significant contingent liabilities as it granted generous government guarantees to state-owned enterprises (SOEs), notably those involved in highway construction, railway infrastructure and shipbuilding.

As a result, Croatia had a relatively highly leveraged private sector at the time the crisis started, even though public indebtedness stood well below the EU average. With the onset of the crisis, the sudden halt in financial inflows, coupled with a rapid contraction in external and domestic demand, exposed existing vulnerabilities in the real sector. Prevailing debt stocks also hindered a smooth adjustment in the financial system in response to the deterioration in the external environment.

A counter-cyclical policy loosening by the monetary authorities allowed buffers in the financial system to absorb the shock and accommodate the adjustment of the Croatian economy in the initial phase of the crisis. The conduct and effectiveness of these policies is described in detail in Section 3.3. Non-financial corporations (NFC) used the breathing space afforded by these policies as an opportunity to refinance existing liabilities, including external liabilities. This prevented a stronger reduction of the debt level, but did not stop a steep decline in new investment. Even so, negative feedback loops from deleveraging pressures, economic recession and the weak fiscal position of the sovereign continue to weigh on the economy. The following subsections look at the drivers of indebtedness and the dynamics of deleveraging in the private sector (Subsection 3.2.2.) and public sector (Subsection 3.2.3.) in greater detail. Subsection 3.2.4. concludes with a discussion of outstanding policy challenges related to indebtedness and deleveraging.

3.2.1. Private sector indebtedness

Strong consumer and business optimism, abundant international capital flows and risk-appetite in the financial sector allowed a quick accumulation of debt by the private sector in the run-up to the global financial crisis. The Croatian economy was not alone in witnessing a significant increase in financial liabilities (Graph 3.25), but its debt did accumulate rather fast in comparison, even taking into account the relatively limited initial levels of external indebtedness. Growth in household debt outpaced that of corporate debt, partly reflecting a lower base, but also loose lending policies on the part of banks. A widespread practice to extend credits linked to the Swiss franc to unhedged borrowers generated an exchange-rate risk for households and a corresponding credit risk for banks (see also Section 3.3.). ([25]) Rising residential prices also contributed to the increase in household indebtedness, as housing loans were leveraged against increasing collateral values. Thus, the household debt-to-GDP ratio peaked at 42% by the end of 2010. As for corporates, a gradual rise in indebtedness culminated with a steep increase at the peak of the business cycle, and the debt-to-GDP ratio surged nearly 30 pp from 2007 to reach 95% in 2010, supported by strong borrowing by both private and public companies.

The onset of the crisis did not bring about immediate deleveraging pressures. On the contrary, debt accumulation, in particular by companies, initially continued (see Box 3.3 for a sectoral analysis of corporate leverage). This was mostly due to refinancing provided by foreign parents (reflected in a growing stock of cross-border intra-company loans), but also accommodative monetary policies that ensured sufficient domestic liquidity. With the nominal debt level increasing, the prolonged economic contraction resulted in a further rise in the private sector debt-to-GDP ratio. Thus, it surged by 20 pp in only two years, peaking at 137% of GDP by the end of 2010, leaving the private sector amongst the most indebted in comparison to regional peers (Graph 3.25). The increase was almost entirely accounted for by the corporate sector, while households managed to keep their liability level relatively stable despite some pressures arising from the increase in the kuna-denominated household debt as a result of the steep appreciation of the Swiss franc in 2010. This affected loans (mainly housing and car-purchase credits) linked to the Swiss currency, putting a strain on the household debt-service burden.

In view of the continuing weakening of economic activity, rising unemployment, and the high debt levels, deleveraging pressures built up as of 2011. This led to some modest decrease in private sector leverage as net credit flows to the domestic economy turned negative in 2011. Thus the total private sector debt-to-GDP ratio fell by 5 pp since the peak at the end of 2010. Nearly four-fifths of this decrease was accounted for by companies, although the figures overestimate the actual adjustment due to the transfer of loans to shipyards to the government accounts in 2012.

Negative credit flows have driven deleveraging. Having averaged around +15% of GDP in the period 2002-2008, net credit flows to the private sector turned negative in 2011 as strong contraction in corporate credit exceeded the remaining flow of credit into the household sector. Credit to the private sector fell more steeply in 2012-13. Inflation helped to curtail the private sector debt-to-GDP ratio through the denominator (Graph 3.26 and Graph 3.27). Valuation changes in the form of debt write-offs also played a role in the corporate sector, although their contribution was limited.

The reduction in corporate sector indebtedness continues at a slow pace. Debt refinancing, reflecting ongoing support from parent companies, but also the tendency of banks to renew debts even to risky creditors (bankruptcy proceedings and collection of debts are complex and costly), could explain the relatively subdued pace of deleveraging in the corporate sector. On-going and elevated borrowing by publicly-controlled companies also acted to moderate the overall pace of adjustment in the corporate debt-to-GDP ratio, as did the weak economic performance through falling nominal output (other than in 2011). However, when measured against total assets (or equity), the corporate debt ratio kept rising throughout the period, thus implying growing financial risks (Graph 3.28).

The household sector also faces deleveraging pressures. These stem from the rapidly deteriorating labour market and falling disposable income. Negative wealth effects as a result of declining residential and equity prices may also play a role. ([26]) As a result, there has been a steep drop in the stock of some types of consumer credit (notably car loans and credit card lending). At the same time, the stock of outstanding housing loans, which account for approximately half of the total household debt, remained relatively stable, thus preventing an even sharper rebalancing of the households’ liability position. This was, however, largely due to the aforementioned negative foreign exchange rate effects associated with the appreciation of the Swiss franc (see also Section 3.3). ([27]) Vulnerabilities nevertheless remain limited due to the still relatively low level of household debt compared to the EU average.

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Box (continued)

Cross-country comparison reveals that Croatia's private sector is more indebted than those of other countries in the region. Indeed, while during the boom years, households and firms in Croatia built up debt at comparable speed to the CEE10, the downturn in Croatia came later and the pace of deleveraging was slower (Graph 3.29 and Graph 3.30). As a result, by the end of 2012 Croatia's firms and households were more indebted than their peers in the CEE10 – by 6 pp points and 7.1 pp of GDP for households and corporations, respectively. This could impact negatively on Croatia's economic growth prospects and competitiveness going forward.

Supply constraints have contributed to the gradual deleveraging of the economy as parent financing for the foreign-owned banking sector was reduced. This process was particularly prominent in 2012, reflecting a shift in funding from cross-border operations to domestic financing. The sharp drop in banks’ foreign liabilities (almost one-fourth in the period from the peak at end-2011 to August 2013) highlights the scale of reduction of external funding for the financial sector which was partly cushioned by offsetting counter-cyclical measures on the part of the monetary authorities. The pace of bank deleveraging largely abated in 2013, while increased domestic savings also compensated for the shortage in foreign funding. The latter, moreover, contributes to mitigating the impact of possible capital outflows, e.g. due to further potential downscaling of financing by foreign banks in view of tighter capital regulations and their on-going balance sheet adjustment.

The National Bank of Croatia (HNB) has been active in ensuring sufficient liquidity in the system to support credit flows. ([28]) However, these efforts have been so far insufficient to compensate for reduced corporate credit demand due to the recession. Furthermore, lenders grew more cautious to counter the worsening of their balance sheets, as reflected by a steep increase in the share of NPLs. ([29]) As a result of negative feedback loops from rapidly deteriorating public debt dynamics (see Subsection 3.3.3.), the domestic banks are becoming more closely linked with the sovereign: since 2008, the larger part of the growing government financing needs has been raised from the domestic market. This could potentially put banks at risk and reduce credit availability for the private sector in case rising public debt is not put back to a sustainable path. ([30]) However, risks of a severe credit crunch appear to be mitigated by the still strong, well-capitalised and liquid foreign-owned banking system, a functional capital market, and the commitment of foreign parent banks under the Vienna Initiative to maintain historic liquidity levels in the region.

Supply factors could lead to further de-leveraging of the private sector as banks focus on lending to the government and SOEs. Indeed, a certain credit substitution of private sector loans with credits to the government appears to have taken place since the end of 2011. In particular, while the credit to the government has increased by HRK 14 billion since 2011, the stock of credit institutions’ claims on the non-financial private sector has contracted by a similar amount (see Graph 3.31). However, the fall in private sector credit seems to be largely linked to declining demand by both households and corporations as a result of ongoing correction of their balance sheets and very weak economic activity. It was also seriously affected by one-off factors such as corporate credit takeover by the state.

The government has undertaken measures to strengthen pre-bankruptcy procedures (see Box 3.4) These steps could facilitate the deleveraging process in the economy, in particular in the corporate sector. At the same time, regulatory uncertainty, including on taxation and on the possible development of a system of energy certificates for certain residential sales, could lead to lower household credit demand and depressed activity. The household sector does appear to have maintained payment discipline and to be in a more favourable position to withstand deleveraging pressures in the medium term, also given its lower initial leverage. Nevertheless, a possible upturn in consumer credit will largely depend on a turnaround of the negative trends in the labour market and household income. Negative risks thus attach to a prolonged recession depressing household spending power.

3.2.2. Public indebtedness

The ongoing deleveraging pressures in the private sector arise at a time of significant fiscal challenges for the country. To the extent that deleveraging trends in the private sector are reflected in weak investment and household consumption, this in turn depresses revenues and accentuates the consolidation challenge for public finances, re-enforcing potential negative feedbacks to the real economy.

Loose fiscal policy during the cyclical upturn limited the room for Croatia to respond in a counter-cyclical manner once the crisis started. The prolonged recession has caused sustained tax revenue losses that have only partially been offset by numerous indirect tax increases, mostly VAT and excises (Graph 3.32). Decisive reforms of the public administration, healthcare and pension systems could have alleviated pressures arising from the expenditure side of the budget, but were delayed. Sizeable subsidy payments and recurrent capital injections into loss-making state-owned enterprises contributed substantially to overall expenditure pressures. Moreover, the fiscal position further deteriorated because of the increase in the budgetary interest burden following activation of state guarantees on loans extended to state-owned enterprises (mostly in the now privatised shipbuilding sector). ([31])

Croatia’s general government deficit averaged 6.1% of GDP in the period 2009-2013. This figure, which reflects the negative impact on public finances from the recession, is not significantly different from the government deficits recorded in a number of CEE10 countries (Graph 3.33), but gives rise to greater concerns due to the relatively higher debt level and Croatia's lower near-term growth prospects. The Commission Winter 2014 forecast shows an

improvement in Croatia's budget deficit in 2014-15 mainly as a result of the one-off effect of transferring a part of the assets from the second pillar private pension system to the first – state -pillar. Under the ESA95 accounting rules, which will be replaced in September 2014 by ESA2010, the headline general government deficit would improve to 5.4% and 4.7% of GDP in 2014 and 2015, respectively. Abstracting from this, there would be a marked deviation in the medium-term fiscal trends of Croatia. Croatia’s structural budget deficit is projected at 5.3% of GDP on average in the period 2014-2015 compared with only 2.2% for the CEE10 (see Graph 3.34).

Persistent primary budget deficits, rapidly growing interest expenditures and negative stock-flow adjustments have resulted in a sharp deterioration of Croatia’s general government debt since the crisis. These developments, combined with nominal GDP remaining below its 2008 peak for a long period, boosted the government debt-to-GDP ratio by nearly 30 pp in four years to estimated 64.9% of GDP at the end of 2013 (Graph 3.35). ([32]) Although this ratio still remains well below the EU average, it is among the highest among the CEE Member States and remains subject to numerous sustainability risks.

The relatively short maturity structure of public debt also has implications for sustainability and debt management. It exposes the country to vulnerabilities stemming from a possible worsening of financing conditions on global markets that would further increase the already high borrowing costs. The sovereign financing needs, consisting of debt (including short-term debt) refinancing and the net lending/borrowing by the state, will continue to grow, reaching close to 20% of GDP in 2014. While rollovers, including of instruments denominated in foreign currency, are concentrated in the first few months of the year, the government is already largely pre-funded for 2014.

Weak state-owned companies continue to cloud the prospects for public finances. Their liabilities have occasionally migrated into the government's balance sheet and thus served as an important factor for the growing deficit and debt figures in recent years. In the absence of more ambitious restructuring efforts in the railway and road infrastructure companies, the main recipients of state guarantees, the risk of additional debt pile-up for the state remain significant.

A high foreign exchange share of the public debt exposes Croatia to potential currency shifts. ([33]) A number of empirical studies highlight unfavourable exchange rate shocks as a source of risk for Croatia’s debt sustainability. ([34]) These risks should be viewed against the good track record of the central bank of ensuring stability of the local currency against the euro, a policy made necessary by the high euroisation of the economy. International reserves, coupled with considerable forex proceeds from the tourist sector, further contributes to the stability of the local currency.

Several factors mitigate public finance risks. Croatia benefits from a relatively deep financial market that for the time being has been able to meet the financing needs of the state at a relatively low price. This refers to both short-term financing needs (covered mostly by commercial banks) and long-term ones (institutional investors, namely pension funds). High liquidity in the banking system, supported by expansionary central bank policies, coinciding with a period of weak credit demand from the real sector, have made lenders focus on financing the state, thus bringing domestic borrowing costs for the sovereign to record low levels in 2013 (Graph 3.37). Furthermore, despite rating downgrades, the country successfully tapped international markets in November 2013. However, it should be noted that growing external debt service costs are exerting significant pressures on the budget, narrowing the possibility for growth-enhancing spending in a situation of weak revenue proceeds and insufficient expenditure-side reforms.

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Box (continued)

The state's asset management activities also affect the debt and fiscal risks. The banks were successfully privatised before the crisis, which brought revenues and increased the stability of the sector (see Section 3.3.). The privatisation process has continued at a slow pace, but there has been limited investor appetite for the state's remaining assets since the crisis and the government did not achieve its targeted sell-off revenues in 2013. If the planned sale of the biggest insurer and the possible concession to run the highways were transacted, this would lead to a significant rise in proceeds in 2014 and thus have a positive impact on the public debt dynamics. The restructuring of troubled state-owned companies could also have an indirect positive impact by reducing contingent liabilities and possible future government expenditures (in the forms of subsidies or re-capitalisation costs). The weight of contingent liabilities has already declined with the restructuring of the shipbuilding sector and could further diminish if re-organisation in the railway sector is stepped up.

3.3. MONETARY AND FINANCIAL SECTOR ISSUES

Croatia is experiencing the after effects of a period of rapid credit growth, driven by internal and external financial institutions. While the authorities used macro-prudential measures to limit lending from domestically-supervised banks, indebtedness still grew very rapidly due to both external borrowing (directly from the foreign parent banks of Croatian subsidiaries) and borrowing from non-bank financial intermediaries. With the deterioration in the financial position of the corporate sector, banks' non-performing loans (NPLs) to corporate borrowers have reached high levels. Still, the conservative approach adopted by the Croatian National Bank (HNB) to macro-prudential regulation, notably in relation to capital levels, has meant that banks have built up a degree of resilience that has proven to be useful given the challenges they now face from the weak economy.

In order to assess the extent to which the financial sector can contribute to imbalances and risks, this section begins with a brief review of macro-prudential policy in the run-up to the crisis. It continues with an overview of monetary and exchange rate policy, before analysing the situation of the banking sector.

3.3.1. Macro-prudential policy in Croatia in the run-up to the crisis

Macro-prudential and monetary/exchange-rate policies have been closely interlinked in Croatia. The authorities sought to internalise the potential risks to financial stability associated with being an economy subject to volatile capital flows and exhibiting a high degree of euroisation. In an environment of rapid financial liberalisation and with insufficient support from fiscal policies, the HNB relied on macro-prudential measures to limit balance sheet risks for banks, slow down the pace of credit growth and increase the banking sector's resilience against the vulnerabilities of financial euroisation.

Managing balance sheet risk

Limits on banks' net open foreign exchange positions sought to avoid currency mismatches on banks' balance sheets. Raising or lowering the limit allowed the HNB to affect credit conditions. The limit was initially set at 20% of regulatory capital, but was raised to 30% during the crisis, mainly to allow banks to take on foreign currency loans or deposits without having to increase their assets.

The authorities sought to take into account indirect credit risk for banks stemming from currency mismatches on borrowers' balance sheets. From 2004, the HNB tightened capital requirements for lending in foreign currency through higher risk weights on loans denominated in or indexed to foreign currency. From mid-2006, an additional 25% risk weight add-on had to be applied for foreign currency loans to unhedged borrowers, and at the beginning of 2008, the add-on was raised to 50%. The measures had to be abolished at the beginning of 2010, as the implementation of Basel II no longer allowed for higher risk weights for foreign currency loans. The HNB responded by raising the required minimum capital ratio from 10% to 12%. Under Basel III, the HNB now explicitly accounts for currency-induced credit risk in its supervisory review process (pillar 2).

Measures to contain credit growth and increase reserve buffers

Measures were put in place to slow down the pace of credit growth. The first measure to be implemented was the 'credit growth reserve' (2003 to early-2004), which required banks to purchase low-yielding central bank bills in the event of a more than 4% expansion of credit in a given quarter. The measure was partly effective in containing lending growth, but it also produced evasion effects as lending activity was shifted to leasing companies or replaced by direct cross-border lending by parent banks. In addition, it may have distorted competition by discouraging smaller banks from expanding more rapidly and gaining market share.

Some of the negative side effects of macro-prudential measures were addressed. From mid-2004, the 'credit growth reserve' was replaced by a measure targeting banks' external funding sources. The so-called 'marginal reserve requirement' obliged banks to deposit between 24% (2004) and 55% (from late 2005) of their newly incurred foreign liabilities in non-interest bearing accounts with the central bank. ([35]) From early 2006, the marginal reserve requirement was complemented by a 'special reserve requirement' to be applied on banks' liabilities from newly issued securities. Both measures were removed following the onset of the crisis in October 2008 to allow parent banks to support their subsidiaries. Between 2007 and 2009, a revamped version of the credit growth reserve was put in place, this time covering a broader set of assets and reducing the lending growth ceiling to 1% per month.

Reserve requirements on deposits were also used. These ranged from 17% to 19% in the pre-crisis period. From December 2008, the HNB cut reserve requirements in various steps to stimulate lending and assist government programmes for providing cheap loans to the corporate sector. In December 2013, the reserve requirement stood at 12%.

Liquidity management

As the HNB faced constraints in fulfilling its function of lender of last resort to the heavily euroised banking system, banks were required to build their own foreign exchange liquidity reserves. In 2003 a 'foreign currency liquidity requirement' was introduced, prescribing that banks hold 35% of their total foreign currency liabilities (including deposits) in liquid assets with a maturity of no more than three months. The rate was lowered in several steps in the course of the crisis to reach 17% in 2013.

Assessment and challenges

The macro-prudential policies ensured that banks built up capital and liquidity buffers, which were both useful during the crisis. In particular, the marginal and special reserve requirement and the higher risk weights applied to foreign currency-loans to unhedged borrowers helped to build significant loss-absorbing capacity, with capital adequacy ratios of about 20% for the largest banks. The banking sector was also well prepared to cope with the almost complete cessation of foreign inflows in late 2008/early 2009, thanks to high foreign currency liquidity buffers in the system.

As the experience of other countries demonstrates, even well-designed macro-prudential measures can give rise to substantial "leakages", and may not be fully effective in containing credit growth. ([36]) In the presence of credit growth limits, foreign-owned subsidiaries helped arrange cross-border borrowing from parent banks and set up leasing companies to shift part of the lending activity off balance sheets. Banks also attempted to circumvent the foreign currency liquidity requirement by offering kuna deposits indexed to an exchange rate. While leasing companies were brought under the supervision of the non-bank regulatory agency HANFA and the foreign currency liquidity requirement was extended to cover currency-indexed deposits from 2006, the HNB's ability to reign in cross-border lending remained limited.

While the banking sector is largely shielded from direct exchange rate risk, it is still exposed to foreign-currency-linked credit risk. The practice of extending loans either denominated or indexed in foreign currency transferred the exchange rate risk to banks' clients, large parts of which were unhedged, even though export-oriented companies and about 10% of households have access to foreign income (remittances, tourism). In the dominant euro-denominated loan segment, the risk is limited by the authorities' commitment to a broadly stable HRK/EUR exchange rate. In the Swiss franc-denominated loan portfolio, however, credit risk started to materialise in the form of rising NPLs, following the appreciation of the Swiss franc against the kuna in autumn 2011. Meanwhile, NPLs for household loans remain well below those for corporate loans.

3.3.2. Monetary and exchange rate issues

Maintaining a broadly stable exchange rate of the kuna against the euro has been a key element of Croatia's economic policy strategy. The exchange rate as a nominal anchor is considered important for two main reasons. First, it serves as a key anchor for price stability given the country's high import-dependency. Second, it is important from a financial stability perspective due to the high foreign currency exposure of both the public and the private sector. The degree of financial euroisation in Croatia is among the highest in the world, which stems from a strong preference of the population for saving in foreign currency, combined with an obligation on banks to adjust the currency structure of assets and liabilities. ([37]) While the kuna is the currency used for payments, the vast majority of savings and loans are either denominated in or linked to foreign currency (71% of loans and 83% of deposits). Apart from the euro (61% of outstanding loans and almost all foreign currency deposits), the Swiss franc plays a role, though its importance has gradually decreased since the crisis (to about 10% of outstanding loans).

The exchange rate regime can be described as a tightly managed float. Over the past decade, the HRK/EUR exchange rate has remained broadly stable, with movements between 7.1 and 7.7 (Graph 3.38). The central bank does not defend a pre-determined target rate or band, but aims at countering excess volatility. It uses macro-prudential tools and occasionally intervenes on currency markets. Foreign exchange reserves stood at EUR 12.9 billion at year-end 2013, equivalent to around 29% of GDP and covering close to 90% of short-term external debt. Although the pace of reserve growth has slowed down following the outbreak of the financial crisis, Croatia continues to accumulate foreign currency reserves. However, this also reflects borrowing on external markets, notably by the government, which brings its own vulnerabilities.

In nominal and real effective terms, the kuna remained broadly stable during 2013. While it appreciated by 1½% in nominal effective terms, it remained almost unchanged in real effective terms (Graph 3.39). A slight nominal depreciation against the euro was counterbalanced by an appreciation against the US dollar, the Chinese yuan and the Russian ruble – the currencies of Croatia's most important non-euro area trading partners. In real-effective terms (CPI-deflated), the kuna has benefited from slightly lower inflation compared to trading partners since mid-2010, which resulted in a slightly lower real-effective exchange rate path as compared to the nominal-effective rate.

In contrast to many other countries in the region, Croatia experienced relatively low and broadly stable inflation during the past decade. While inflation has been very sensitive to commodity price shocks (food prices in 2007-8, energy prices in 2012), the responsiveness to the business cycle has been more muted, both during the boom period and during the crisis. Annual inflation was 2.8% on average during the past decade, the third lowest among the CEE and Baltic countries. Since the onset of the crisis in 2009, annual inflation has come down to 2.2% on average.

The low inflation environment allowed the HNB to maintain an accommodative monetary policy stance, with continued high liquidity provision to the banking sector. Between December 2008 and year-end 2013, it decreased reserve and liquidity requirements in various steps and implemented credit support schemes involving the Croatian development bank HBOR. However, with the exchange rate as the monetary policy anchor and given the high level of euro-denominated debt, the central bank's room for manoeuvre remains limited. An improvement in macroeconomic fundamentals, in particular export competitiveness, would help to underpin exchange rate stability in the medium-term and increase leeway for monetary policy to support the recovery of the economy.

3.3.3. The situation of the banking sector

Croatia's banking system is characterised by a high degree of foreign ownership, minimal state presence, and capital levels among the highest in the region. The banking sector as a whole has total assets of EUR 54 billion, or about 130% of domestic GDP, which is on the high side for the CEE region. ([38]) There are around 30 banks in Croatia, with the five largest, representing 75% of the system, being subsidiaries of banks from Italy and Austria (see Table 1). State ownership is limited to two banks, representing only around 5% of total banking assets. ([39]) Foreign parent banks of Croatian subsidiaries generally have a strong presence in the region. ([40]) In line with the conservative macro-prudential approach taken by the HNB, the reported capital adequacy ratios of the largest foreign banks stand at above 20%, while liquidity coefficients remain well above the minimum required ratios. Mid-sized banks have a reported average capital adequacy ratio of 16.6%. Compared to large banks, mid-size banks are proportionally more exposed to corporates, and less exposed to the government and the retail sector.

The high degree of foreign ownership of banks in Croatia (Table 3.1) has generally been seen in a positive light. There is evidence that foreign banks can play a stabilising role during crises and can bring benefits such as increased efficiency, the transfer of knowledge (including knowledge of bank management and risk management) and the stability of lending relationships. ([41]) Foreign ownership should also, in principle, help to limit linkages between the sovereign and the banks, notably in cases where additional capital may be required. However, market structure is highly concentrated, with the largest bank accounting for over a quarter of banking assets, and the two largest accounting for over 40%.

One of the major challenges facing Croatian banks is the high level of NPLs to corporates, although their rate of increase has slowed recently. The protracted weak macroeconomic environment has had a significant effect on banks' asset quality. Overall NPLs reached 15.3% at end 2013, up from 14% one year earlier and 5% in 2008 (Graph 3.40 and 3.41). ([42]) This effect has been strongest in the corporate sector, with NPLs at 27.4% in the same period, up from 24% in the previous year. Corporate NPLs are highest in construction and real estate as well as the wholesale and retail trade sector. In terms of currency, NPL are higher for CHF-denominated loans, which rose from 35.8% in June 2011 to 52.9% in September 2013. In comparison to other countries that experienced a similar GDP contraction in recent years, NPLs are high. However, the year-on-year growth in corporate NPLs slowed to 12% in 2013, from 23% in 2012. While provision coverage ratios have been increasing recently, they are low in comparison to other countries and the past. Since NPLs are one of the main channels through which the state of the economy can impact banks' balance sheets, their future evolution needs to be closely monitored. It has to be noted that some corporate loans may need to be restructured, which could result in higher provisions, but in some cases banks might be inclined to keep funding non-viable businesses rather than take additional losses.

Domestic banks were not the main drivers of the rise in corporate indebtedness. As noted above, various macro-prudential measures limited the role of domestically-supervised banks in aggregate credit supply during the 2000s. Consequently, the rise in corporate indebtedness was mainly driven by increased external borrowing, with a prominent role played by foreign parent banks of Croatian subsidiaries (Graph 3.42). The credit risk for these loans remains with the parents. Similarly, lending to corporates was also channelled through non-bank financial intermediaries, notably leasing companies, again with the intention of circumventing the HNB's macro-prudential restrictions on banks. All large international bank groups present in Croatia have leasing subsidiaries generally funded through parent banks. When leasing companies became subject to stricter regulation, the sector underwent a substantial deleveraging (Graph 3.43).

NPLs in the household sector are well below those for corporates, but are also growing more rapidly. At the end of 2013 household sector NPLs stood at 10.6%. While household NPLs increased relatively rapidly between 2008 and 2010, their growth subsequently slowed. More recently, however, there has been acceleration in the growth of household NPLs, from 10% year-on-year growth in 2012 to 17% year-on-year in 2013, driven by a strong increase in NPLs for mortgage loans. Despite this, household NPLs remain well below the levels reported for the corporate sector. A key part of the explanation for the better performance of household loans seems to be that payment discipline by mortgage borrowers is relatively strong in Croatia compared to some other countries, while loan-to-value (LTV) ratios did not rise as much as elsewhere. However, the evolution of household NPLs differs with the currency of denomination. In June 2011, NPLs for household loans stood at 6.8% in both the euro- and CHF-denominated segments. By end-2013, NPLs for household loans rose to 13.3% for CHF-denominated loans, whereas in the euro-denominated portfolio the corresponding figure was 8.6%. While banks have transferred the exchange rate risk for these loans to the borrowers (many of whom are unhedged), the strong preference by borrowers for foreign-currency-linked loans does create indirect credit risk for banks. The existence of this risk helps to explain why the HNB adopted a conservative approach to bank capital levels in recent years.

Bank liquidity conditions have been improving. With increased risk aversion by the private sector, deposit volumes have increased and deposit funding has become cheaper for banks. This along with more readily available domestic retail funding (deposits), has led to an improvement in the loan-to-deposit ratio (Graph 3.44) and has also enabled the large banks to pay back foreign liquidity sources (credit lines and interbank-loans) and reduce their reliance on parent funding. This has reduced the degree of funding vulnerability of Croatian subsidiaries. Conversely, medium-sized banks are historically more reliant on domestic sources of funding and less affected by potential foreign deleveraging. Loan-to-deposit ratios are lower than in other countries that experienced rapid credit growth in the recent past, and which should support a revival in credit growth once demand picks up.

Croatian banks remain profitable, but profitability has nevertheless come under pressure from several sources. Rapid deleveraging in the corporate sector has meant that many loans are not being renewed, which reduces banks' ability to earn interest income. Both deteriorating asset quality and deleveraging are negatively affecting the business performance of the Croatian banks, while margins are also under pressure. Bank profits fell by 28% year-on-year in 2012 and by preliminary 70% year-on-year in 2013, but still remained positive and higher than in neighbouring countries throughout the crisis, due in part to the high flexibility in adjusting interest rates in the past, as well as to improvements in operating efficiency more recently. In 2014 profits are expected to come under further pressure, given the stricter regulation on provisions for late-stage arrears (an increase by 10% a year independently of collateral valuations), the new minimum haircuts on property collateral valuation, and the reduction in lending volumes.

Croatian banks' interest margins have come under pressure. This is mainly due to weak loan demand from households and NFCs, and a reorientation of lending towards less risky clients (the general government sector and SOEs) where the interest rate charged would typically be lower. Furthermore, interest income has also fallen as a result of increasing NPLs, and also as a result of the different regulations on the setting of interest rates. The combined impact of these factors is reflected in the lowest net interest margins since 2008 with annual net interest income falling to 2.5% of average assets from 2.9% in 2011. Although the interest margin is diminishing, there is little room for the banks to increase lending rates given the weak economy.

The various measures regulating the setting of interest rates could give rise to a number of adverse effects for the economy and for borrowers. There are three different types of interest rate regimes that banks are obliged to apply. First, on retail loans denominated in Swiss Francs, a maximum interest rate of 3.23% was set, which is a lower rate than on other loans, despite the fact that no new CHF-denominated loans have been sold for the past five years. Second, a ceiling has been imposed on the maximum interest rate that can be charged to clients in arrears (11% for retail and 15% for corporates). In addition to negatively affecting banks' ability to earn interest income, an adverse side effect of this regulation is that it may not be profitable for banks to lend to less creditworthy borrowers, and there is a risk that some borrowers could be forced to look for credit from less well regulated lenders. Third, in setting interest rates to clients, banks are required to choose one among five benchmarks plus a margin. Most large banks have chosen Euribor, which is currently at historically low levels, with the consequence that interest rates for clients can likely only increase. Moreover, Euribor may not be a reliable indicator of Croatian banks' funding costs, given that they also have to internalise CDS spreads. Although this particular measure was taken with the aim of increasing transparency for customers about the lending rates that banks charge, it risks introducing market rigidities and reducing competition, thus potentially leading to counterproductive outcomes. Furthermore, it could limit banks' ability to supply credit to the real economy.

Weak loan growth to the private sector appears to mainly reflect reduced demand for credit, as the subdued macroeconomic environment has led households and NFCs to deleverage. Given that Croatia has experienced five consecutive years of recession, demand for credit has fallen sharply. Weaker credit demand stems mainly from small and medium-sized enterprises (SMEs) and in relation to long-term credit. Still, the HNB reports that SMEs continue to need access to credit for working capital purposes and to refinance existing debt, but that they are facing tighter credit standards. ([43]) According to the latest EIB CESEE lending survey, credit supply conditions for mortgages, large companies and long-term loans have tightened and are expected to continue doing so in the next months. Tighter credit standards are partly a consequence of banks' increased risk-aversion, which is not only due to the interest rate caps, discussed above, but also due to the need to keep risks and capital under control. The EIB survey found that, while credit demand remains weak, it is expected to expand slightly, also due to the positive impact of debt restructuring actions.

Banks have responded to reduced private demand for credit by increasing the supply of loans to state entities, but this could give rise to problems further down the road. Total loans by monetary financial institutions to the Croatian economy peaked at EUR 46.9 billion in March 2012. Since then, loans to the general government sector and SOEs have increased, while loans to the rest of the economy have fallen (see Box 3.6.). Loans to the private sector have contracted by EUR 2.2 billion or almost 5% from their peak, which has been mainly driven by the strong reduction of loans to NFCs. By October 2013 bank credit to NFCs had declined by 12.6% from the peak in March, while credit to households had fallen by 4%. Weak loan demand from households likely reflects, among other things, worsening labour market conditions, notably the increase in the unemployment rate. In contrast, loans to the general government have been rising, reaching 11% y-o-y growth in the first ten months of 2013 (see Graph 4 in Box 3.1). Viewed from a pure banking/credit-risk perspective, an increase in loans to SOEs may not necessarily be problematic provided the enterprises are creditworthy. However, a continuation of these trends would be incompatible with a reduced role for the state in the economy. There may also be doubts about the longer-term viability of many SOEs. Furthermore, there are important contingent liabilities for the government associated with guarantees to SOEs. Finally, it will be important to ensure that there has not been a structural shift in banks’ risk appetite to the detriment of newer, private companies.

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Box (continued)

Balance sheet repair, together with other initiatives, should help strengthen the capacity of banks to support the economy. Factors that are weighing on bank profitability, and thus constraining their ability to lend