CE Financial Observer: Before our meeting, I looked at the ratings and was surprised that Croatia, a member state of the EU, has a rating six notches lower than Poland and seven notches lower than the Czech Republic. Are the credit rating agencies treating your country fairly by assigning it with a sub-investment grade?
Boris Vujčić: It’s enough to look at what happened with the market prices of the Croatian debt to see that the agencies are usually a bit behind the markets. The spread on credit default swaps on the Croatian debt fell by more than 200 points. The markets are already noticing that the surplus on the current account is stable and that the public debt has started falling. Meanwhile, agencies must first change the outlook before they change the rating, and this happens slower than on the market.
So there are no longer any obstacles for ratings to be upgraded?
The current rating outlook indicates that the ratings may follow the changes that we are already seeing on the market. Of course, the ratings are also a more comprehensive assessment of a country’s condition. In every country there are things that can be improved. In the case of Croatia, this would mainly involve structural reforms, which must be continued.
Do you mean the 83 per cent debt-to-GDP ratio?
Yes. This ratio peaked at 86 per cent, but has now fallen to 83 per cent and will drop below 80 per cent. A positive trend is visible and lasting, and it results both from fiscal discipline, and the return of GDP growth.
The forecasts predict that GDP growth will be around 3 per cent in the coming years, but just a few years back it was zero. Was this due to the crisis in the Eurozone or because of internal reasons?
Chronologically speaking, I would put internal causes first. Even before the crisis, we had an unstable model of growth based on large inflows of capital, which created an imbalance: a high level of external debt and a high level of public debt. When, during the crisis, our partners also got into trouble, this inflow of capital stopped. At that point this model showed its weakness and we had to restructure it. Croatia has gone from a 9 per cent current account deficit before the crisis to a surplus of almost 5 per cent. This is 14 percentage points, which shows how much our economy has changed.
Was it easy to make this change?
This reduction took a couple of years. At first it involved a reduction of imports for about three years starting from 2008, and since joining the European Union in 2013 we’ve been observing an increase in exports, which are now the main source of our GDP growth.
During that time you had the Croatian version of quantitative easing. What did it involve?
I wouldn’t call it quantitative easing, but it was undoubtedly a very expansive monetary policy. When one compares the expansion of the Croatian National Bank’s balance sheet with the expansion of the FED balance sheet or that of the European Central Bank, it turns out that our expansion was even faster.
How did we do it? We provided large amounts of liquidity, not through asset purchases, but using more conventional tools. At the beginning this was a reduction of the required reserve ratio in both the domestic and foreign currency, so it resulted in higher liquidity both in the HRK and in foreign currencies. The next stage involved purchases on the foreign exchange market, because with a surplus on the current account we need to buy a lot of currencies, which creates even more liquidity in the market.
Could this type of expansive policy be maintained on a permanent basis?
If we look at the situation with the inflow of capital, it is clear that we have to build up reserves through purchases on the foreign exchange market, because otherwise the HRK would significantly weaken. We don’t want that, because our long-term policy aims to stabilize the exchange rate. Of course, I don’t mean a fixed exchange rate, but simply preventing excessive appreciation or depreciation trends within a floating exchange rate system. In the long term, depending on the inflation forecasts, we will also have to adjust the other instruments of our monetary policy.
I was surprised that as much as three-fourths of all savings in Croatian banks are denominated in the EUR. As I understand it, this is the result of old savings denominated in DM (German marks)?
We do have an unusual structure of savings, and because of that, for example, the benefits of the adoption of the EUR by Croatia would be higher than in other countries. You have correctly pointed out that this structure of savings is nothing new. In the times of Yugoslavia, people were saving money in DM. When Croatia became independent, up to 90 per cent of all savings were denominated in that currency, which was then replaced with the EUR.
Has Croatia ever considered unilateral adoption of the EUR?
We never decided to peg the exchange rate of the HRK to the EUR, but the system is de facto euroized. After all, the banks have the EUR on the side of the liabilities, and on the side of the receivables they must also have a diversified currency structure. This is due to the fact that they grant loans in the HRK, but index them to the EUR, and therefore most of the loans are sensitive to the exchange rate of the foreign currency. That is why we do not have a lot of flexibility when it comes to the exchange rate policy.
As I said, we cannot allow the currency to strengthen too much, because this could cause a loss of competitiveness of our country, which has become an exporter. We also cannot allow the currency to weaken too much, because that would increase our debt – all the instalments of loans would go up if the HRK weakened in relation to the EUR. So since the exchange rate policy cannot be used in Croatia anyway, the cost of giving it up during the possible adoption of the EUR is close to zero.
When, therefore, will it be possible to reduce the debt above the required 60 per cent threshold and when will Croatia be ready to adopt the EUR?
I don’t know when we will be ready, we don’t have a timetable for the adopting of the EUR. We only launched a public debate on this issue at the end of October (read more) and we need to reflect on the benefits and the costs. When it comes to the fiscal rules that you mentioned, we already adhere to the rule that every year we have to reduce the debt by 1/20 of the difference between the target level of 60 per cent and the current level of public debt. At the moment we are even doing this at double the rate and in the foreseeable future of two to three years we will probably maintain this good pace.
When do you think countries of Southeast Europe, but also more broadly, of Central and Southeast Europe (CSE), will follow in the footsteps of the United States and begin the cycle of tightening monetary policy?
I should not provide such forward guidance for countries other than my own. I will say in more general terms that I’m not surprised by the fact that the countries of Central Europe are a little ahead, because the Philips curve is still alive there – you can see that the salaries are going up and that the wage pressure resulting in inflation will be more present there than in the countries of the so-called old Europe. In such circumstances, it is also logical that the monetary policy cycle will begin quicker in Central Europe.
Could quantitative easing carried out through asset purchases also be a tool in our region during the next crisis?
It is difficult to predict the next crisis, but we do know that there was no such need during the previous one, and I do not expect that to happen anytime soon.
Boris Vujčić, PhD, is the Governor of the Croatian National Bank.