CROATIAN BANKS ARE STABLE, FOR THE MOMENT

UNCLAS SECTION 01 OF 02 ZAGREB 000727

SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN HR
SUBJECT: CROATIAN BANKS ARE STABLE, FOR THE MOMENT


1. Summary: Croatia's economy and banking system remain
reasonably stable, although not entirely immune to the
effects of the world financial crisis. The central bank has
temporarily removed a restrictive reserve requirement on
Croatian banks that draw credit from abroad. The government
also announced it will increase deposit insurance from
100,000 kuna (14,000 euro) to 400,000 kuna (56,000 euro).
The Croatian National Bank (HNB) claims this amount covers 90
percent of deposits in Croatia. The banking sector, although
largely foreign-owned, has shown few signs of true crisis.
Croatian banks have benefited from a restrictive monetary
policy that has limited credit exposure abroad.
Nevertheless, there is clear unease in the press, which
tracks almost daily the woes of Croatian banks' European
parent institutions. Croatia also has a large foreign debt
and current account deficit, which represent significant
risks. Flows of foreign direct investment, which had been
adequate to cover the deficit, are forecast to decline.


2. Summary continued: The main Zagreb stock market index, the
Crobex, has also been volatile. The index lost 30 percent of
its value last week, only to rebound significantly early this
week. It then fell again 8 percent on October 15, due partly
to a press report linking Raiffeisenbank (Austrian bank with
a large presence in Croatia) to financial institutions in
Iceland. The true level of consumer confidence in the
economy and the banking sector remains unclear, but sales of
big ticket items, such as new cars, are already hurting in
the uncertain climate. Overall, officials and experts with
whom we spoke agree Croatia is withstanding the crisis as
well as can be expected, but that the economy remains
vulnerable. End summary.

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Banks Foreign-Owned, but Insulated
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3. Approximately 90 percent of Croatia's banking sector is
foreign-owned, mostly by other large European financial
institutions. All the parent banks of Croatia's major banks
have experienced large drops in share prices this year.
Italian UniCredit (owner of Zagrebacka Banka) and Intesa
SanPaolo (owner of Privredna Banka) have experienced drops of
48 percent and 69 percent, respectively. These two banks
comprise approximately 50 percent of the Croatian banking
sector. Austrian Raiffeisenbank (owner of a Croatian
subsidiary of the same name) has seen a 53 percent drop in
its share price so far this year. There have been no major
signs of mass withdrawals by Croatian depositors, although
there were briefly long queues at Zagrebacka Banka two weeks
ago after the press reported widely on UniCredit's
difficulties.


4. Despite foreign ownership, Croatian banks enjoy
significant structural and regulatory advantages. First,
local banks are distinct legal entities and are capitalized
domestically, largely through deposits rather than lines of
credit from other banks. In 2006, the HNB imposed a
restrictive 55 percent reserve requirement on capital raised
from abroad. This "tax" discouraged most banks from
borrowing abroad and has correspondingly limited their
exposure to risk. (NOTE: This reserve requirement has
recently been removed temporarily in an effort to increase
liquidity in the capital markets). The HNB has also
maintained a strict credit expansion ceiling introduced last
year. According to the EBRD Director for Croatia, the HNB's
policies have been prescient in limiting risk to Croatia's
banks, while encouraging them to build a strong domestic
deposit base. However, one of President Mesic's economic
advisors told us he remains unconvinced that these advantages
will prove sufficient should the situation continue to
deteriorate for the European parent banks.

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Foreign Debt and Current Account Deficits Worrisome
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5. Both Croatian officials and international financial
institution representatives have told us that Croatia's
foreign debt, currently 95 percent of GDP, is a large area of
concern. In the new environment of tight credit markets, the
EBRD believes the government will be forced to shift its
borrowing needs to the domestic market. Domestic credit will
be more expensive, but will reduce exposure to financial
shocks from abroad. However, private corporations and
households account for a much greater share of the foreign
debt, around 50 percent. According to the World Bank, this
could increase the speed and magnitude by which financial
turbulence in Europe could transmit to Croatia.


6. Croatia's current account deficit also remains high, at
8.6 percent of GDP. This could be problematic, since the
government has relied on significant foreign direct

ZAGREB 00000727 002 OF 002


investment (largely through big ticket privatizations) to
cover the deficit. These FDI inflows are likely to shrink
since there are few major government assets left to sell.
Shipyards are a large asset the government plans to privatize
next year, but the success of the sale is both politically
and financially uncertain. Without FDI to cover the deficit,
the government will have to rely on further borrowing in a
very unfavorable credit market.


7. Another critical source of foreign currency inflow is the
tourism industry, accounting for over 20 percent of GDP.
The president of the Croatian Association of Hotel
Operators told the press that tourism will be among the
industries hardest hit by the global financial crisis.
Indeed, unofficial data indicate an effect already, recording
a 9 percent drop in the number of tourists for September 2008
as compared to 2007.


8. A lower availability of credit for companies and
individuals will force adjustments in personal expenditures
and limit new business enterprises. Coupled with higher than
expected inflation this year, the Croatian consumer could see
some hard times ahead. The EBRD has correspondingly adjusted
its 2008 GDP growth forecast for Croatia from 6 percent to
3,8 percent. The World Bank forecasts 4.5 percent growth.


9. COMMENT: The unknown factor is Croatians' true level of
confidence in the banking sector. Given the financial
history of the country, Croatians have more reason than most
to be skittish depositors and investors. The collapse of
Ljubljanska Banka after the breakup of Yugoslavia wiped out
many Croatians' savings and legal proceedings to recover them
continue to this day. Croatians also remember the high
current account deficits of the late nineties, which in 1998
precipitated a severe banking crisis followed by a recession.
Consumer confidence is probably not aided by the press,
which reports dire warnings of imminent European bank
collapse one day, followed quickly by euphoric headlines when
the stock market rebounds. A story on October 15 describing
supposed ties between Raiffeisenbank and financial
institutions in Iceland appears to have led to a rapid 6
percent decline in the Crobex. For these reasons, the
government's increase in deposit insurance is a logical, and
probably effective, first step. But it is clearly too early
to say the Croatian economy is out of danger from turbulence
in the European financial markets.
Bradtke