Governor Vujčić's Parliamentary address

Published: 4/3/2016

Dear Mr Speaker, ladies and gentlemen Members of the Parliament, ladies and gentlemen,

in accordance with the law, the Croatian National Bank informs the Croatian Parliament about its financial condition, the level of price stability achieved and monetary policy implementation on a semi-annual basis. Accordingly, this Annual Report of the Croatian National Bank has been submitted to the Croatian Parliament. As part of my presentation, in addition to the information on the financial condition, the level of price stability achieved and the monetary policy implementation, I will once again review the possibilities and the role of the monetary policy in the economic recovery and growth of the Republic of Croatia. With this in view, let me begin with an assessment of the general pace of economic activity in the previous period.

The real GDP mostly stagnated at the low level of the end of 2013, while the gross domestic product in the Republic of Croatia reduced by 0.4% in real terms on an annual level due to the decline in economic activity in the second half of 2013. The gross value added (GVA) decreased in most activities, above all in construction and the primary activities of agriculture, forestry and fishing. On the other hand, manufacturing showed signs of recovery. Overall, since the onset of the crisis the cumulative fall in economic activity has reached 12.4%.

In 2014, a positive contribution to economic developments came primarily from the growth in exports. In contrast, however, domestic demand continued to contract, again primarily due to the renewed slump in investments, household deleveraging and a negative economic outlook.

Such trends in the real economic activity also affected the labour market. The number of employed persons stagnated at the low level reached at the end of 2013, decreasing by 0.9% on an annual level (excluding the administrative removal in October 2014) due to the strong decline in the second half of 2013. By contrast, the number of unemployed persons registered with the Croatian Employment Service (CES) decreased sharply. This was predominantly a result of the increased removal of unemployed persons from the CES register due to their failure to meet legal requirements. When speaking about the average registered unemployment rate in 2014, it went down slightly to 19.7%, from the 20.3% in 2013. The relevant internationally comparable ILO unemployment rate remained at the average of 17.3%. As for the labour cost, data show that nominal wages held steady (0.2%), while real wages edged up (0.4%) due to the fall in consumer prices.

As for the general price level: the average annual consumer price inflation rate dropped from 2.2% in 2013 to –0.2% in 2014. The average annual rate of change in the core Consumer Price Index, which, among other things, excludes prices of energy and agricultural products, but includes processed food products, totalled –0.4% and was more pronounced than the rate of decline of the overall index. It should be noted that inflation developments were predominantly driven by a decrease in raw material prices in the world market, in particular the prices of food, which spilled over to domestic prices. The contribution of unprocessed and processed food products to annual inflation thus decreased from 1.5 percentage points in 2013 to –0.3 percentage points in 2014. In addition, the sharp decrease in the world crude oil prices in the last quarter of 2014 spilled over to domestic prices. The trend of a decline in crude oil prices was visible in the global market since July and gained momentum in November and December, with the average price of Brent crude oil of USD 56 in late 2014 being 50% lower than in mid-year. Weak foreign and domestic economic activity and low core inflation in the euro area also contributed, though to a lesser extent, to the decline in domestic inflation in 2014. The absence of domestic cost pressures, which is evident in stagnant unit labour costs, further supported low inflation.

And now more about Croatia's foreign trade, capital flows and external debt:

For the second year in a row, the balance of payments current account boasted a surplus, totalling 0.7% of GDP, as compared to 0.8% of GDP realised in 2013. The greatest contribution to such a result came from the exports of services amid the growth of tourism revenues, as well as goods exports outstripping goods imports. At the same time, increased profits of banks and enterprises in foreign ownership and increased interest expenses on foreign liabilities, primarily of the state, worked in the opposite direction. In addition, the surplus decreased from the previous year because the funds received from the EU funds allocated to final users were lower than government payments to the EU budget. However, it is important to keep in mind that the current and capital accounts only show the funds paid out to end beneficiaries, while the funds received, but not yet allocated, are recorded on the financial account. Taking into account the non-allocated funds as well, the overall balance in transactions with the EU was positive in 2014. 

Foreign capital flows in 2014 were mostly influenced by an improvement in the net debt position of banks, which reduced their foreign liabilities and increased their foreign assets at the same time. By contrast, government debt increased, albeit much less than in 2013, as the government covered some of its financial needs in advance in late 2013. Net foreign direct investments were larger than in 2013, mostly due to higher profits of foreign-owned domestic banks, while inflows of equity investments, excluding the impact of a round-tripping direct investment in 2014, were weaker than the year before. The bulk of investments related to other business activities, real estate activities and hotels and restaurants.

A review of Croatia's net debt position of Croatia shows that its improvement, which began as early as 2011, continued into 2014. Net external debt was reduced by EUR 0.5bn, to EUR 25.2bn at the year-end, or 58.5% of GDP. In contrast, gross external debt grew by EUR 0.8bn in 2014 and reached the figure of EUR 46.7bn. Its growth was exclusively a consequence of the negtive effect of cross-currency changes caused by the strengthening of the US dollar against the euro, although protection against currency risk is embedded in the majority of bond issues. The relative indicator of gross external debt deteriorated due to the rising debt and falling GDP, reaching 108.4% of GDP in 2014.

Total international reserves of the Republic of Croatia stood at EUR 12.7bn at the end of 2014, down 1.7% from the end of the previous year. The reserves decreased on account of the net sale of foreign currency, totalling EUR 0.2bn, and a withdrawal of funds from the government’s foreign currency deposit with the CNB, while they were given a boost from investment income and foreign exchange gains. In contrast to gross reserves, net usable reserves went up by EUR 0.1bn in 2014 (1.3%), to EUR 10.7bn at the year-end. Notwithstanding the decrease in gross international reserves, the indicator of their adequacy, measured by the coverage of short-term external debt by remaining maturity, improved slightly. At the end of 2014, this indicator stood at 92.2%, 0.7 percentage points up from the end of the previous year.

As usual, in 2014, international reserves continued to be managed according to the principles of high safety and liquidity. The annual rate of return on the CNB dollar-denominated held-for-trading portfolio was 0.24%, and that on the euro-denominated held-for-trading portfolio 0.42%. The improvement of the held-for-trading portfolio performance from 2013 is a consequence of the lower yields and higher prices of German and US bonds as well as the higher prices of other euro-denominated bonds in which international reserves are invested. The euro-denominated held-to-maturity portfolio, which is invested in longer-term bonds with higher yields, had a rate of return of 2.06% in 2014.

Turning to the banking sector which was also affected by the previously described unfavourable macroeconomic developments. The indicators of bank profitability in 2014 were much below the levels which are considered to be good, although they improved slightly from 2013, and bank profit recovered in 2014, following a sharp decline in 2013. Reduced expenses on loss provisions were the main factor contributing to the increase in profit, even though they continued to impose a heavy burden on the operating results of banks. In addition to reduced expenses on loss provisions, recovery in earnings was also the result of higher operating income mainly attributable to a fall in deposit interest rates and lower costs of the sources of financing and further efforts towards business optimisation. Income generated from the sale of parts of operations rose, while the general costs continued to fall and income from fees and commission rose considerably. However, interest income, as the main source of earnings, continued to fall as a result of slow credit activity, rising non-performing loans and new consumer credit rules. In accordance with the said developments, profitability indicators improved from the previous year, with the ROAA rising to 0.6% and ROAE to 3.6%.

Profitability was hindered by growing losses in banks' loan portfolios as unfavourable macroeconomic developments and the absence of recovery in economic and credit activity had an unfavourable impact on the quality of banks' loan portfolios. The share of partly recoverable and fully irrecoverable placements in total placements stood at 16.9% at the end of 2014, an increase from the 15.7% recorded at the end of 2013, keeping credit risk cost at an elevated level. After declining for three consecutive years, in 2014, banks' off-balance sheet liabilities rose by HRK 2.7bn, mainly driven by an increase in liabilities towards companies. As regards the structure of off-balance sheet liabilities, the increase was mainly associated with an increase in credit lines and assumed commitments to finance public enterprises, while the increase in banks’ off-balance sheet exposure to other companies was mostly due to issued guarantees.

However, the banks' high capital adequacy ratio made them resilient to possible macroeconomic disturbances. The rate of the total own funds of banks rose slightly towards the end of 2014 and stood at 21.4%, an increase from 21.0% recorded at the end of the previous year. The introduction of the new capital regime (CRR/CRD IV) in 2014 helped keep operating risks adequately covered, the condition also supported by a high level and quality of capital items and the adopted measures on capital buffers. At the same time, own funds and total risk exposure declined, although the decline in total risk exposure was more pronounced due to a fall in credit risk exposure. The capital position of banks was positively influenced by an increase in the coverage of non-performing loans which rose in 2014 from 46.2% to 51.3%, thus alleviating the negative potential impact of credit risk on bank stability. The capital adequacy of housing savings banks rose considerably, from 20.5% at the end of 2013, to 23.5% at the end of 2014, largely due to a reduction in credit risk exposure, in much the same way as in the case of banks.

And finally, very briefly about fiscal indicators and public finances. The public finances in 2014 were largely marked by Croatia's implementation of the Excessive Deficit Procedure. In the conditions of economic stagnation and low inflation and consolidation efforts notwithstanding, key fiscal indicators deteriorated further. The simultaneous introduction in October of 2013 in all EU member states of the statistical methodology ESA 2010 added considerably to the worsening of the quantification of fiscal indicators (particularly public debt level), the situation which took place in only a few EU member states, Croatia included.

I would now like to focus on monetary policy and the role of the Croatian National Bank. In 2014, the Croatian National Bank continued to pursue an expansionary monetary policy, maintaining at the same time the stability of the exchange rate of the kuna against the euro, as a key priority to maintaining financial stability. The expansionary character of the monetary policy was seen primarily in the efforts to ensure high levels of kuna liquidity in the monetary system. However, high liquidity is not an objective in itself; the central bank's efforts are aimed at contributing to the improvement in the conditions of financing of all entities on the domestic market. In 2014, credit institutions had on average higher kuna liquidity surpluses than in 2013, which helped keep the overnight interest rates on the interbank market and T-bills market at very low levels. The high liquidity also had a favourable impact on the fall in lending and deposit interest rates of domestic banks.

In addition to keeping high liquidity, the CNB also worked towards boosting the growth of placements to the economy by purchasing CNB bills. From end-2013, the central bank supported credit activity by purchasing subscribed compulsory CNB bills before due date from those banks that recorded an increase in loans to companies. Despite such efforts, the domestic credit activity failed to pick up in 2014. The reasons for that should be sought in subdued investment demand in the conditions of high over-indebtedness of companies, inadequate collateral against the backdrop of falling real estate prices, further household deleveraging, low level of business and consumer optimism and a large share of non-performing placements and risk aversion of banks and business entities. The placements of credit institutions to the domestic sectors (excluding the central government) thus fell in 2014 by 3.0% (exchange rate changes excluded), their largest annual decline since the beginning of the crisis.

To sum up: Using its monetary policy instruments, the CNB supported the improvement of the financing conditions for the government, banks and the private sector and encouraged lending on the domestic market, maintaining at the same time the stability of the nominal exchange rate of the kuna against the euro as a key precondition to preserving financial stability. Despite all these efforts and as a result of a failure to implement structural reforms, in 2014 (and earlier) Croatia lagged behind considerably in reversing the negative trends and spurring real growth, when compared to the new EU member states. The areas which call for further and stronger efforts towards the implementation of structural reforms are primarily the improvement of the business climate and competitiveness of the domestic economy, followed by an increase in foreign direct investments which will boost exports. The monetary policy will support such efforts by all monetary policy instruments available to it and by keeping adequate financial system liquidity, preserving at the same time the stability of the exchange rate of the domestic currency.