The response of monetary policy to recession: evidence from Croatia.

• Date: 01 January 2010
• Author: Borozan, Djula

1. INTRODUCTION

   Croatia, as a small open and transitional economy is strongly connected regarding international trade and financial transactions with the world market, first of all with the EU (especially in terms of financial transactions) and Central and Eastern Europe (CEE) markets (especially in terms of trade transactions). Since it almost entirely liberalized its trade and capital transactions, each significant disturbance on these markets has to be reflected on the Croatian economy. Croatia has experienced the onset of the world financial crises and its spillover effects onto the real sector, i.e. recession slightly later than the other EU countries. Economic disturbances have become more expressed since the second quarter of 2008 when economic activity measured by real gross domestic product (GDP) has started to slow down. In the last quarter of 2008, according to the Croatian Central Bureau of Statistics (CBS), growth rate amounted only 0.2% relative to the same period in the previous year. Negative growth rates in further quarters have been the basic characteristics of GDP movement onwards.

   The slowdown of GDP in 2008 was primarily consequence of the decline in the domestic demand, i.e. household consumption and gross capital formation, from 4.2% and 9.8% in the first quarter of 2008 to 3.2% and 3.5% in the last quarter of the same year, respectively. Such adverse development was provoked by the downfall in business, contraction in consumer optimism and increased uncertainty regarding the severity and duration of recession. Financial crises and recession, that initially started in the USA and severely affected the European business partners, had adverse impact on Croatian exports and foreign direct investment (FDI). FDI in Croatia are mainly brownfield investments. In addition, the most of big state enterprises were privatized. Therefore, exports responded firstly on changes in global environment: slowing down was recorded in the third quarter of 2008. In the last quarter of the same year it fell by 2.5% compared with the same quarter in 2007. An extremely sharp fall in export volume, -17.6%, was recorded in the third quarter of 2009 indicating by this severity of recession. Since imports cut down more sharply, from -7.1% to -23.5% in the same time period, the huge chronic trade deficit was mitigated, but only in statistical terms.

   Negative trends in GDP have been followed by the same unfavorable trends in the other economic indicators such as industrial production, real income, retail sale, employment and unemployment. In 2009 and at the beginning of 2010 they have continued to develop in an adverse manner. This has led Croatia to the most severe economic downturn from the Homeland war (1991-1995).

   Recession in Croatia, which was triggered by a systematic neglecting the structural, domestic issues, has now developed into an especially severe economic and social disruption which threats to develop into depression in 2010. So, the roots of the Croatian crises are predominantly of internal character. The crises stems from structural defects such as deficient innovations, low productivity, technological level of production and added value, poor management and leadership shortfall capacities in private and public sector, ineffective and inefficient business models in companies, and in government administration on all levels as well as too expensive government that does not provide value for money and that has been failing to create favorable and fair business environment. Economic growth was driven primarily by final consumption, and this could not be sustainable and priceless. The world and domestic recession put the main, but 'old' Croatian challenges--high current account deficit and foreign debt--into more complicated context. Current account deficit was EUR 4.4bn, i.e. 9.2% of GDP, and foreign debt EUR 39bn, i.e. 82.6% of GDP in 2008 (CNB, Statistics, 2010). In 2010 it is likely to expect the worsening of the problems in economic terms; for example, increase in the share of foreign debt on 100% of GDP (Rohatinski, 2009b). Maintaining the external liquidity, foreign exchange stability and solving and mitigating the consequences of domestic recession when the economic prospects of the global economy remain fraught with uncertainty, defined not only the bulk of economic activity in Croatia, but also the challenges and frames to macroeconomic policy.

   Monetary and fiscal authorities across the globe have responded quickly to adverse economic developments. So did the CEE and Croatian authorities. Although, the most forecasters expect that the global economy is likely to recover in 2010, albeit at a gradual pace, there is a still threat that contemporary global recession will be W-shaped. The CEE countries have experienced the onset of recession with a certain time lag, but they still have to deal with it.

   The main purpose of this paper is to analyze and discuss the monetary policy responds on financial crisis and recession that have marked Croatian economy since the end of 2008. This paper proceeds as follows. In section 2, monetary policy and the role of Croatian National Bank in Croatia are briefly explained. Discussion of monetary policy responds on financial crises and recession is the subject matter of Section 3. Finally Section 4 concludes the paper.

2. MONETARY POLICY IN CROATIA

   Monetary and foreign exchange policy in Croatia is guided by the Croatian National Bank (CNB). According to the Act on the CNB (Official Gazette 36/2001), it is the Croatian central bank, autonomous and independent in its work and responsible to the Croatian parliament. Central bank independence considered in terms of functional, institutional, personal and financial independence is of high level (Coric and Cvrlje, 2009). Having independent central bank firmly committed to achieving its objective is worldwide recognized among central bankers as a prerequisite for an effective monetary policy (see for example Stark, 2009). The prime objective of monetary policy in Croatia is to maintain price stability and the operative objective is to maintain the stability of the national currency, Croatian kuna (HRK), i.e. financial stability. It also supports the economic policy of the Republic of Croatia, while acting in accordance with the principle of an open market economy with free competition, without prejudice to the achievement of its prime objective. CNB, as many other central banks, has an important impact on the economy and economic growth in the short run. In Croatia, CNB has got not only a key role in struggle against inflation, but also in struggle against financial crises and recession. Macroeconomic policy in Croatia is aliened with the new consensus approach which gives monetary policy an important role in the stabilization of the output and employment in the short run, while assuming that in the long run monetary policy is neutral and only affects inflation (see for new census models for example Hein and Truger, 2008; Fontana, 2009).

   The arena for conducting monetary policy in Croatia is the managed floating exchange rate regime whereby euro is set as the main nominal anchor. Consequently, the CNB allows the exchange rate changes depending on the foreign exchange supply and demand on the foreign exchange market within the narrow, to the public relatively unknown borders. Such monetary-exchange rate regime reflects a high level of currency substitution (i.e. euroization) of the Croatian economy in general and especially of financial sector taking into consideration that the most part of bank assets and liabilities are nominated in foreign currency or indexed to foreign currency. (1) Croatian monetary policy has been very effective in achieving its objectives since 1993, i.e. after suppressing the hyperinflation in 1993 and in maintaining stability of the financial sector. Financial stability refers to the smooth functioning of all financial system elements in the resource allocation process, in risk assessment and management, payments execution, as well as in the resilience of the system to sudden shocks (CNB, Financial stability, 2009).

   The Governor of the CNB, Z. Rohatinski (2009a) stresses...