CROATIA FOREIGN DEBT WORRIES CENTRAL BANK,

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SIPDIS

SENSITIVE

SIPDIS

E.O. 12958: N/A
TAGS: ECON EINV HR
SUBJECT: CROATIA FOREIGN DEBT WORRIES CENTRAL BANK,
BUT OTHERS UNCONCERNED


SENSITIVE BUT UNCLASSIFIED; PLEASE HANDLE
ACCORDINGLY.


1. (SBU) Summary: Croatia's foreign debt as a
percentage of GDP reached 82.4 percent at the end of
2005 and has continued to climb in the first quarter
of 2006, with some analysts predicting it could
reach 86 percent of GDP by year's end. This
seemingly insatiable appetite for foreign borrowing,
led by Croatia's mostly foreign-owned banks, has
come despite a decreased reliance on foreign credit
to finance the state's budget shortfalls and
draconian reserve requirements enacted by the
Croatian National Bank. However, although many in
Zagreb's financial community have expressed concern
over such high levels of foreign debt, few believe
that the country is headed for a debt crisis.
Although large in its aggregate, the structure of
Croatia's foreign debt is more favorable than in
many countries that have experienced debt crises.
With most liabilities long-term and strong foreign
reserves, analysts here believe Croatia is in a
relatively good position to service its debt,
barring an external shock. End Summary.

Credit Boom Increases Foreign Debt
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2. (SBU) The Croatian economy has experienced a
credit boom in recent years, led by pent up demand
for imported consumer goods and a mostly foreign-
owned banking sector competing for market share.
The banks, over ninety-three percent of which are
under foreign ownership (mostly Austrian and
Italian),have now replaced the state in their share
of Croatia's overall foreign debt. Out of a total
foreign debt of 26.2 billion euros - a stunning 82.4
percent of GDP - banks now account for 38 percent,
as opposed to the state's 26.2 percent. The
remaining 35.8 percent reflects private sector debt.
The banking sector in Croatia has been enormously
profitable in recent years, with interest rates
several points over the average in the euro-zone.
This has encouraged banks operating in Croatia to
increase inflows of lending capital from their home
offices abroad, which is then used primarily to fund
consumer lending, particularly mortgages and auto
loans.

Central Bank Reaction
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3. (SBU) The Croatian National Bank has attempted
with limited success so far to temper this credit
boom by imposing increasingly draconian reserve
requirements on bank capital from abroad. In
December of 2005, the Bank raised these requirements
to 55 percent after previous measures failed to slow
credit growth. Damir Bronic, risk manager for
Austrian Erste Bank in Zagreb told us that the
current rates are likely to bring the results the
Central Bank has sought, as the commercial banks
cannot lend profitably with such a high reserve
requirement. Bronic said the banks are now faced
with a choice between lending at a loss to increase
market share or attempting to attract new domestic
deposits. He predicted that most would opt for the
latter option, although initial figures for the
first quarter of 2006 still show strong credit
growth in the banking sector, so the effect of the
Bank's measures are yet to be seen. Many Croatian
economists are concerned that so much lending is
directed at consumption, rather than business
investment. However, measures that increase the
cost of money will also increase the cost of
investment and could have negative consequences for
employment and overall economic growth.

Debt High But Manageable
--------------


4. (SBU) Apart from some academics, few in Zagreb's
financial community appear overly concerned about
Croatia's ability to service its debt. They point
to several reasons for this. First is the fact that
the structure of Croatia's debt is generally
favorable. Most of the debt is long-term, avoiding
a sudden balloon repayment scenario that would leave

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lenders running for the exits. Furthermore, since
the banks are borrowing from their home offices,
they have wide latitude to restructure debt. Second
is the fact that Croatia has relatively high levels
of foreign reserves, driven both by tourism and
foreign investment. Croatia's foreign reserves are
over 6.5 billion euros, the equivalent of
approximately 5 months of imports. Finally,
Croatia's banking sector, although foreign owned, is
operating in Croatia, making it unlikely that the
parent banks would jeopardize their operations in
the country.

Kuna Strong Despite Debt
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5. (SBU) One of the peculiarities of Croatia's
circumstances is the fact that the national
currency, the kuna, has had a tendency to appreciate
despite the high levels of debt and a ballooning
trade deficit. IMF Zagreb Rep Athanasios Vamvakidis
points out that this is partially due to the fact
that Croatia's economy is so tightly linked to the
economies of the euro zone. Tourism (which accounts
for about 20 percent of Croatia's GDP),investment
and the increasing inflow of pre-accession funds
from the European Union all put upward pressure on
the kuna. So far, the Central Bank has so far been
able to keep a stable exchange rate against the euro
through periodic market intervention. Maintenance
of the exchange rate is critical for Croatia, as the
vast majority of consumer debt is linked to the
exchange rate, so that any significant fall in the
value of the kuna could have catastrophic
consequences for debtors whose income is in kunas.
The relatively high value of the kuna, however, has
also been a curse for the Croatian economy, as it
has fueled demand for imports and is a factor in
making many Croatian exports relatively
uncompetitive.

External Crisis Wild Card
--------------


6. (SBU) That Croatia's foreign debt and indeed its
economic growth are sustainable in the near term is
generally accepted in the financial community here.
However, there are a number of external wildcards
that could have significant consequences for
Croatia. Velimir Sonje, an economic analyst who
consults for Erste Bank told us that sustained high
oil prices could worsen Croatia's economic picture
and the government's fiscal balance. The GOC, in an
effort to soften the impact of rising gas prices on
Croatian motorists and businesses is now considering
reductions in the excise tax on fuel to head off
even sharper price increases. While welcome for
motorists, this loss of revenue could make it more
difficult for the government to meet deficit targets
and force the state to resort to borrowing to cover
these gaps. Perhaps more worrisome, however, is the
prospect of sharp rises in interest rates in the
euro zone. If high energy prices trigger inflation
in the euro zone and lead the ECB to raise rates
sharply, these rate hikes would have a direct impact
on Croatia, not only by increasing the price of new
borrowing, but also by increasing the cost of some
debt service. The result of this could be a
contraction in credit on the domestic market that
not only would dampen business investment, but would
also dampen consumer spending, which has been one of
the main drivers of Croatia's GDP growth in the last
several years.

FRANK