5 and their asset size rapidly shrank with the fall in share prices in the second half of 2008.<sup>2</sup> For this reason, we will not pay great attention to non-bank financial institutions in this article.

# _2.2.  Monetary policy instruments_

The choice of monetary policy instruments in Croatia flows mainly from deposit euroization and strong capital inflows. Because of the foreign currency-induced credit risk in the banking system, the central bank has adopted a policy of broad exchange rate stability. The kuna-euro exchange rate stayed within an interval of +/- 6.5 percent during the whole 1993–2011 period. The central bank reacts more to the rate of change of the exchange rate than the level and generally has not announced any targets or target bands.

Capital inflows to Croatia have been substantial. To avoid excessive appreciation, the central bank purchased foreign exchange from banks; but to limit potential credit expansion and keep monetary conditions from becoming too loose, it had to sterilize. However, sterilization via the issuance of central bank paper bearing market interest rates was abandoned at the beginning of 2003 because of the possibility of substantial central bank losses. Furthermore, it seemed possible that raising interest rates on central bank paper would not even succeed at controlling money growth in light of the ability of foreign banks to provide additional funding to their Croatian subsidiaries. This additional funding could have allowed the subsidiaries in turn to purchase any increase in central bank paper while also expanding lending at their ex ante desired rate. This led the central bank to look for sterilization instruments that would not in and of themselves directly occasion capital inflows.<sup>3</sup> Additionally, there is some evidence that increased interest rates on domestic currency loans led to substitution into foreign currency-indexed loans. Kraft and Galac (2011) estimate a simple VAR model based on Brzoza-Brzezina et al (2010). The impulse response functions suggest that most of the decrease in domestic currency loans is compensated for by increased foreign currency loans. They also look at the effect of the central bank measures to increase the price of foreign currency (-linked) lending to borrowers who are not hedged against currency risk, from mid-2006 to early 2010. The conclusion is similar, at least in the pre-crisis period, but this time it is the increase in domestic currency lending that compensates for decreased foreign currency (-linked) lending.

It is interesting to note that neighboring Serbia chose to issue central bank bills despite these arguments. Ultimately, high interest rates did limit loan demand because the elasticity of loan demand was not in fact zero. But this approach, while relatively transparent in the sense that interest rates on central bank paper were formed in the market, allowing monetary policy to use an interest rate channel, was also quite costly and may have increased capital inflows and appreciation pressure.

The Croatian approach, in contrast, relied on high and uniform reserve requirements on bank deposits in both domestic and foreign currency, coupled with a marginal reserve requirement on increases in bank foreign liabilities. Remuneration of required reserves was kept

> 2 For time series data on financial system shares through mid-2007, see the CNB Macroprudential Bulletin #6, p. 29. 3 Naturally, any form of sterilization that succeeded in limiting the money supply would raise interest rates, ceteris paribus. There would always be a large positive differential between the interest rate on bank loans in Croatia and the interest rate on similar loans in the euro zone (unadjusted for risk). However, if sterilization were done via the issuance of central bank paper at market rates, the central bank would pay this market rate on its liabilities, whereas sterilization through increased reserve requirements at least would not create large interest costs for the central bank.