Rohatinski Forces Companies to Increase Borrowing Abroad

Given the HNB’s intention to discourage credit growth, corporate borrowing will remain the main generator of external debt in the future to compensate for the lack of domestic crediting.

Experiences of transitional economies dependent on capital imports suggest that with minimal budget deficits, or balanced budgets, a fairly high level of balance of payments deficit can be maintained without serious consequences for economic growth. The real question is how does the Croatian economy manage this?! Despite the high growth of the surplus on the services account, disproportionate trends in Croatia’s commodity exchange with abroad are the main culprit for this year’s deterioration of the balance of payments deficit to an expected 8.6 percent of GDP from 7.8 percent last year. The growth of the commodity deficit is determined by the strongest growth in industrial production in the last six years (around six percent), high single-digit growth in investments, and the strengthening of tourist activities.

The contribution of domestic demand is the highest in the last four years and, as usual, it has been fueled by favorable borrowing in the country (population, state) and abroad (companies). This year, the commodity deficit will exceed the level of 10 billion euros for the first time, compared to 8.8 billion last year, which at a level of 27 percent of GDP represents a deterioration of one percentage point of GDP compared to 2006. Far more important than the final result, and considering the short-term trends in the foreign trade balance, is the slowdown of non-oil commodity imports throughout this year, which will continue next year under the influence of the cumulative burden of restrictive monetary policy.

It is encouraging that export growth is somewhat faster than import growth, largely driven by deliveries of plants and equipment and chemical products – both categories of high added value – thanks to the acceleration of economic growth in the eurozone along with the increasing contribution of domestic demand there. At the same time, it should be noted that there is an increased representation of capital goods imports, which should finally positively reflect on the faster growth of private investments in productive capacities in the economy and, in general, lead to an improvement in competitiveness. Given the electoral fiscal ‘relaxation’, the repayment of debt to pensioners (at least 3.3 billion kuna in 2007), credit-financed personal consumption, and the accumulation of investments, as well as the growing import dependence of all forms of final demand, the chances of a significant easing of import demand in the short term are minimal.

On the other hand, even in the case of prolonged above-trend growth of domestic demand in the eurozone, all this ultimately indicates that Croatian exports contribute relatively less to GDP growth, considering also the very low openness of the domestic economy (commodity exports account for only 25 percent of GDP, compared to about 60 percent in Eastern European transitional markets). Furthermore, this year’s expected acceleration of net tourism income growth of 8 percent to 6.2 billion euros should be attributed to a whole range of factors, such as favorable climatic conditions, a strong recovery of living standards in many of our emitting EU markets, and an increase in revenue per available (hotel) room (RevPAR) due to re-categorization and further efforts against the gray economy.

Given that the cumulative effect of administrative monetary restrictions has so far mainly encouraged redistribution within the channels for external borrowing, and that aggregate demand management policies have not been ‘adjusted’, it should not be expected that significant corrections of external imbalances will occur in the medium term. The balance of payments deficit could therefore reach (if not exceed) the level of 10 percent of GDP by the end of this decade, considering that previous foreign direct investments (FDI) have mostly been motivated by investors’ preferences to reach expanding markets in terms of personal consumption, which also does not indicate positive changes in the structure of the domestic economy. Croatia thus remains dependent on foreign borrowing for financing the deficit, but if it wants to improve the export mix towards more luxurious goods and services, characterized by higher added value and low price elasticity, as well as a strong focus on marketing and customer relations.

In the long term, more competitive countries maneuver more skillfully between satisfying domestic or foreign demand, making the aggregate supply simultaneously more resilient to external shocks. Finally, although not least important, levels of the balance of payments deficit are subject to variations in global risk appetite and fluctuations in the income balance, considering the further acceleration of profit growth in non-financial companies (after +25 percent last year) and depending on the preferences of foreign owners of domestic banks regarding profit retention. With a balance of payments deficit above eight percent of GDP, economic growth above five percent, and FDI coverage below 80 percent, external borrowing in capital-hungry Croatia will continue, among other things, due to weak chances for further reduction of inflated public spending. Moreover, not only public investments in infrastructure but also any larger capital-intensive project will inflate external debt given the impractical 0.5 percent non-penalized limits on credit growth for the private sector, along with the already usual concern about crowding out by the state.

Sectorally speaking, considering the unattractiveness of foreign borrowing due to rising capital costs in global markets and increasingly strict credit limits with negative repercussions in banks’ market share battles, increasingly profit-oriented banks are therefore reducing their marginal reserve status after they managed to replace expensive foreign debt financing with approximately one billion euros worth of recapitalizations in the last year. One byproduct of the HNB’s credit limits is intensified direct foreign corporate borrowing at a monthly rate of about 300 million euros, which, combined with the strengthening of private investments, could positively affect import-substituting or export-oriented capacities of the economy in the medium term, so in that sense, monetary authorities should not be concerned. Departing from the orientation towards overall growth of credit to companies in the previous short-term period (see chart), relatively restrained investment growth is explained by the still strong role of the state in the economy, the ‘crowding out’ of private capital investments, and structural inefficiencies, which prevent effective capital inflow into long-term entrepreneurial investments.

All this therefore favors directing part of corporate debt and direct investments towards financing speculation in the real estate market, capital markets, and indirectly consumption, which ultimately raises doubts that the Croatian balance of payments deficit above eight percent of GDP has so far reflected (strong) investments of a certain convergence process. Given the HNB’s intention to discourage credit growth in 2008, as well as the continued 90 percent preference for long-term financing (which implies a high degree of creditor confidence and borrower optimism), corporate borrowing will remain the main generator of external debt in the future to compensate for the lack of domestic crediting.

Further increases in the European Central Bank’s base interest rate (calculated at a level of 50 basis points by spring 2008) combined with the rise of global risk premiums at historical minimums – which complicates the availability of cheap foreign financing – will ultimately encourage more banks to tighten credit standards and finally raise interest rates, unless the risk premium falls significantly. However, until banks actually tighten the credit tap (which should not be overly expected), such minor adjustments actually perform the task of domestic monetary policy. Whether the negative effects in the case of prolonged turbulence in global markets will reflect on the dynamics of investment growth is not yet entirely certain, considering that capital consumption will increasingly be financed through capital markets or direct foreign investments.
* The opinions expressed in the article are not necessarily those of the institution.