NOT FOR
PUBLIC RELEASE
FLOATING WITH A LARGE LIFE JACKET: MONETARY AND
EXCHANGE RATE POLICIES IN CROATIA UNDER DOLLARIZATION
VEDRAN ŠOŠIĆ and EVAN KRAFT
5
10
Even after more than a decade of low inflation, Croatia remains highly dollarized.
Commercial banks avoid currency mismatch by indexing loans to the exchange rate.
Although this eliminates direct currency risk, it creates credit risk, because any larger
depreciation might induce borrower defaults. Monetary and exchange rate policies
focus on exchange rate smoothing to safeguard financial stability. Dollarization
has prevented the use of monetary policy to stabilize output. Given Croatia’s likely
entry into the EU and adoption of the Euro, dedollarization seems unfeasible. Rather
than attempting to reverse dollarization, the central bank has taken measures to make
the banking system more robust to shocks. (JEL)
I. INTRODUCTION
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rate. Although this practice avoids overt currency mismatch on banks’ balance sheets, it
creates an indirect risk of heightened default
if the exchange rate depreciates.
This balance-sheet effect is a familiar problem in dollarized economies, and it is a strong
reason for limiting exchange rate flexibility.
Mishkin (1996) argues that under high dollarization, monetary policy must be concerned
with financial stability first, and only secondarily with output stabilization. This approach
has been followed in Croatia. The abandonment of the output stabilization function of
monetary policy would thus seem to be a cost
of dollarization in Croatia.
One of the puzzles of the Croatian experience has been the persistence of dollarization.
Conventional wisdom suggests that dollarization stems from experience with high inflation,
and can be unwound over time after successful stabilization. However, Croatia has experienced almost 12 years of low inflation at the
time of writing, and there are precious few
signs of any unwinding of dollarization. The
authors will argue, in the same vein as Ize
and Levy-Yeyati (2003), that financial dollarization as seen in Croatia is not easily reversed, and that in fact Croatia is an extreme
case of persistent financial dollarization.
At first glance, Croatia seems to share the
problems of other Central and Eastern European countries. It is a small economy, troubled by large and volatile capital flows
(Šonje and Vujčić 1999) and periods of rapid
credit growth threatening financial stability
(Mihaljek 2003; Kraft and Jankov 2004).
The process of structural change fostering real
convergence toward the EU, coupled with
success in implementing structural reforms,
prompted several of the advanced transition
countries (Hungary, Czech Republic, Poland,
and Slovakia) to gradually introduce more
flexible exchange rate regimes (Corker et al.
2000). However, Croatia differs from these
countries for reasons other than just being
a laggard in the EU integration process. Most
important, it is far more dollarized.
The pervasiveness of unofficial dollarization
greatly affects Croatia’s choice of exchange
rate regime. Croatian depositors overwhelming prefer to hold their deposits in foreign
exchange (mainly euros, but also U.S. dollars).
Croatian banks, to avoid currency mismatch,
issue loans that are indexed to the exchange
*This is a revision of a paper presented at the Western
Economic Association International 79th annual conference, Vancouver, June 2004. The authors are grateful
for the comments and suggestions made by two anonymous referees. All remaining errors are the authors’ sole
responsibility. The views expressed are not necessarily
those of the Croatian National Bank.
Sˇosˇic´: Research Adviser, Croatian National Bank,
Zagreb, Croatia. E-mail [email protected]
Kraft: Advisor to the Governor, Croatian National Bank,
Zagreb, Croatia. E-mail [email protected]
ABBREVIATIONS
GDP: Gross domestic Product
IMF: International Monetary Fund
1
Contemporary Economic Policy
(ISSN 1074-3529)
doi:10.1093/cep/byj033
Ó Western Economic Association International 2006
No Claim to Original U.S. Government Works
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CONTEMPORARY ECONOMIC POLICY
The euro conversion in 2002 provided an occasion for those most skeptical of the domestic currency—those who kept large amounts
of money in foreign currency banknotes—to
change their behavior. Anecdotal evidence suggests that many agents had their life savings
in mattresses and decided to put this money
(mainly German marks) in banks during the
conversion process. However, postconversion
data show that there was a substantial restocking of foreign exchange banknote holdings,
suggesting that the tendency to holding foreign
currency cash, though somewhat reduced, remains strong. Furthermore, the behavior of
deposits since 2002 shows little sign of any
reversal of asset dollarization.
With few hints of dedollarization to be
found, and with adoption of the euro only a
matter of time, there seems to be little reason
for Croatia to change its monetary policy
framework in the next few years. The policy
of limited exchange rate flexibility has helped
prevent any large exchange rate shocks that
might translate into credit quality shocks
and has helped keep inflation low. At the same
time, by avoiding a rigid peg, Croatia’s policy
has helped limit speculation and has diminished moral hazard by encouraging economic
agents to take currency risk seriously. In addition, limited nominal exchange rate flexibility
makes it easier to accommodate the very substantial seasonal variations in foreign exchange inflows and money demand present
in Croatia. For these reasons, the authors will
argue that Croatia’s monetary policy focusing
on a broadly stable but not rigidly fixed exchange rate has been appropriate and will
probably continue to be appropriate through
the euro adoption.
The article is structured as follows. Section
II discusses the pattern of dollarization in
Croatia and its persistence despite a decade
of macroeconomic stability. The authors emphasize developments surrounding the euro
cash changeover, its outcomes, and the lessons
learned from this process. Section III discusses
the implications of the dollarization for monetary policy and explains why dollarization is
so important for the choice of the exchange
rate regime. Balance-sheet effects, the problems of portfolio shifts between domestic and
foreign currencies, and pass-through from exchange rate to prices are discussed in more detail as well as some possible policy responses.
Section IV offers a few conclusions about
Croatian monetary policy and the challenges
ahead.
II. DOLLARIZATION IN CROATIA: THE FACTS
Measured by the ratio of foreign currency
deposits to broad money, a conventional measure of dollarization, Croatia is one of the most
highly dollarized economies in the world.1 Indeed, only 2 out of 52 countries with International Monetary Fund (IMF) arrangements
since 1986, Bolivia and Peru, had deposit dollarization ratios higher than Croatia in the
mid-1990s (Baliño et al. 1999). Deposit dollarization in Croatia even surpassed the most
famous dollarization case of all, Argentina.
In Shi and Honohan’s (2002) later study,
which increased the sample of countries to 58
(see Appendix A), Croatia was overtaken by
the Lao People’s Democratic Republic and
Angola, but remained quite close to the top
of the charts.
Not only is dollarization in Croatia exceptionally high by international standards, it is
also remarkably persistent. Despite average
inflation of 2.8% in the years 1994–2004,2 dollarization did not reverse. The share of foreign
currency deposits in total savings and time
deposits rose from 80.2% in 1994 to 83.9%
in the first half of 2005, whereas the share
of foreign currency deposits in broad money
during the same period increased from
50.0% to 61.9% (see Figure 1).3
1. Dollarization is used here as a technical term,
although the main foreign currency in Croatia is the
euro. Also, by dollarization the authors mean de facto
or unofficial dollarization, or the extent to which foreign
currency is used in domestic economy, rather than de iure
dollarization, which is a normative issue of the choice of
the exchange rate regime.
2. Average of the December-on-December change in
retail prices from 1994–97 and consumer prices from
1998–2004.
3. The 2005 figures include domestic currency deposits
indexed to the exchange rate. Data on such deposits are
only available beginning in 1999. However, the very low
level of such deposits in 1999 (about 3.0% of total deposits) suggests that their inclusion does not substantially alter the time series. Domestic currency deposits indexed to
foreign exchange grew rapidly in response to central bank
regulations issued in January 2003 that required banks to
hold liquid foreign exchange assets equal to 35% of their
foreign exchange liabilities. Indexed deposits were not
included in the definition of foreign exchange liabilities
for the purpose of this regulation. The authors believe that
the higher of the sets of lines, including indexed deposits,
better represent actual deposit dollarization, and that the
decreases in dollarization in the years since 2000 are relatively minor.
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FIGURE 1
Share of Foreign Currency Deposits in Saving and Time Deposits and Broad Money Supply
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%
90
80
70
60
50
4.05
10.04
4.04
4.03
10.03
4.02
10.02
4.01
10.01
4.00
10.00
10.99
4.99
10.98
4.98
4.97
10.97
4.96
10.96
4.95
10.95
4.94
10.94
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Share of foreign currency deposits in savings and time deposits
Share of foreign currency deposits in broad money
Share of foreign currency deposits in savings and time deposits - corrected for indexed deposits
Share of foreign currency deposits in broad money - corrected for indexed deposits
Source: Croatian National Bank.
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Furthermore, compared to other countries
with high dollarization ratios, Croatia has
high levels of banking assets to gross domestic
product (GDP) and broad money to GDP (see
Appendix B). This runs contrary to the usual
notion that high dollarization implies a shallow financial system.
Another piece of evidence suggesting that
the Croatian case is unusual comes from calculation of the minimum variance portfolio
suggested by Ize and Yeyati (2003). They
model financial dollarization based on a portfolio selection approach, with the currency
composition of the liability side of the portfolio chosen by risk averse depositors in a mean
variance framework, and on the asset side by
banks’ desires to limit open foreign currency
positions. In this framework, Ize and Yeyati
show the dollarization ratio is closely correlated with a parameter they call k* or the
MVP dollarization ratio. Their empirical work
finds the following linear relation between actual deposit dollarization and the MVP ratio:
Actual dollarization
¼ 0:794 k* 0:002 inflation
adjusted R2 0:563ð0:106Þ ð0:002Þ
Table 1 shows the value of the MVP ratio for
Croatia compared to actual foreign currency
deposit ratios.
Although the MVP ratio predicts foreign
exchange deposit ratios rather well in Ize
and Yeyati’s cross-section, in Croatia it predicts dollarization levels less than half of the
actual. Furthermore, although the MVP ratio
falls after 2000, in Croatia’s case the deposit
ratio actually rises slightly.
There are multiple reasons for such behavior, the strongest of which relate to financial dollarization.4 Croatian citizens have
been faced with a long history of monetary instability and expropriation of deposits. They
have endured a long history of inflation: Under the former Yugoslavia, sustained inflation
in the range of 15–40% in the 1970s turned into
runaway inflation in the 1980s, culminating in
inflation of 2000% in 1989. The first years after
Croatia’s independence also brought high inflation of 745% in 1992 and 1617% in 1993.
Croatian depositors also have experience
with expropriation, as foreign currency deposits were turned into public debt and frozen in
1991 after Croatia lost the backing of international reserves of the former Yugoslavia. The
government started to repay these deposits in
20 semi-annual installments beginning in mid1995, although some banks initiated efforts to
unblock foreign deposits earlier. In addition,
some savers whose deposits had been in
4. For a more detailed discussion of the causes of
dollarization persistence in Croatia, see Kraft (2003).
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CONTEMPORARY ECONOMIC POLICY
TABLE 1
MVP Dollarization versus Foreign Currency Deposit Dollarization in Croatia
MVP
FX deposit ratio
Predicted ratio
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230
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240
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250
1989:02–2003:04
1994:02–2003:04
1994:02–1999:04
2000:01–2003:04
0.434
0.693
0.345
0.321
0.689
0.255
0.342
0.681
0.272
0.268
0.700
0.212
Ljubljanska Banka, a bank whose headquarters was in Slovenia but had branches in Croatia, were unable to get access to their deposits
after 1991. The case is still pending, with
Slovenia arguing that it is an issue related to
succession from the former Yugoslavia, and
Croatia arguing that the liability of the Slovene bank is clear and unrelated to succession.
Admittedly, it is not clear why this experience would lead to deposit dollarization. In
the first instance, this experience probably
stimulated holdings of foreign exchange banknotes. However, as confidence in the banking
system returned in the mid- to late 1990s, and
as the government began to return most of
the deposits (except for those in Ljubljanska
Banka), savers returned to foreign currency
deposits. Perhaps the repayment, however
drawn out it may have been, convinced savers
that foreign currency savings would be safe
even in the future.
These explanations fit into the classic
explanations for financial dollarization. But
there may also be explanations related to currency substitution. In particular, another explanation for dollarization persistence looks
at the possible role of network externalities
in the usage of currency. In other words, if foreign currency is widely accepted, a high dollarization equilibrium can prevail in which no
one has an incentive to switch back into domestic currency (for elaboration of network
externalities in dollarization see Oomes 2003
and Feige et al. 2002b). By law, transactions
in Croatia must be performed in domestic currency, and transactions in stores, payment of
taxes, and all official payments between firms
are in fact performed in Croatian kuna. However, anecdotal evidence suggests that actual
transactions related to purchases of some
big-ticket items, like apartments or used cars,
are often priced and carried out in foreign currency, although tax authorities record such
transactions in kuna terms. Furthermore, cash
transactions and transactions in the extensive
unofficial economy are generally made in for-
eign exchange. Finally, the geographical proximity of Croatia with EU member countries
facilitates cross-border trade and a constant
inflow of remittances and tourist receipts in
foreign exchange.
Although it appears that some transactions
are carried out in foreign exchange, the majority of transactions in Croatia do seem to be in
domestic currency. This casts some doubt on
the network externalities in transactions argument, although there might be some market niches (e.g., apartments) where network
externalities are set to work. As apartment
purchases often represent investment rather
than consumption, those purchases are more
closely linked to savings motives than pure
transaction motives. Moreover, there could be
a channel between saving in foreign currency
due to fear of large-scale currency depreciation and/or confiscation of bank deposits, and
transaction network externalities in the unofficial economy.
De Nicoló et al. (2003) study different kinds
of network externalities that may be more relevant to Croatia. They look at the possibility
of network externalities in deposit dollarization. Dealing in foreign currency is a safer
strategy if everyone else does so because it
increases the likelihood of bailout of depositors and debtors in the case of a catastrophic
scenario. Moral hazard is present in the high
dollarization equilibrium, because if a critical
mass of other banks take foreign exchange
deposits, than banks can rely on cheap foreign
exchange deposits and afford not to worry
about the possibility of devaluation. Therefore, collective choices about the currency
structure of the portfolio may still impact
choices made by the individual even if actual
transactions are not predominantly carried
out in foreign currency and transaction costs
are not affected.
Finally, it is indicative that despite substantial interest rate differentials in favor
of domestic currency deposits through 2003
(Figure 2), deposit dollarization was not
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FIGURE 2
Interest Rates on Long-Term Deposits and Interest Rate Differentials
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%
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5
0
kuna deposits
interest rate differential
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07.02
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07.01
01.01
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01.00
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01.98
07.97
01.97
07.96
01.96
-10
07.95
-5
foreign currency deposits
actual depreciation (one year ahead)
Source: Croatian National Bank.
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reversed. Deposit rates in Croatian banks on
foreign exchange remained above deposit
rates in EU countries. This supported the
return of deposits held abroad by Croatian
residents and stimulated an inflow of foreign
currency held ‘‘under the mattress’’ as the consolidation of banking system progressed and
confidence in domestic banks rose. However,
it seems that the average premium of about
one and a half percentage points over the actual depreciation rate during the second half
of the 19902 was not nearly high enough to
induce depositors to shift into the domestic
currency (Šonje and Vujčić 1999).5
Thus far, the authors have conformed to
the conventional method of measuring dollarization by using deposit dollarization data.
But this excludes holdings of foreign currency
in circulation, an important element in Croatia. Estimating the stock of foreign currency
in circulation is usually challenging (Feige
et al. 2002a, 2002b), but the euro cash changeover provided a unique opportunity to collect
such data with a great deal of reliability.
According to estimates by the authors based
on bank data, the total of euro legacy currencies in circulation on the eve of changeover
amounted to 3.3 billion euros or about three
5. Depreciation rate against the Deutschemark was
used until 1999 and depreciation rate against the euro
afterward.
times as much as the domestic currency in circulation at that time.6 Deutschemarks comprised about 95% of this cash stock, and the
rest was in the other legacy currencies.
Including these cash balances of eurolegacy currencies into a more comprehensive
measure of dollarization would raise dollarization rate by 7.5 percentage points, from
66.6% (69.2% including kuna deposits indexed
to foreign exchange) to 74.1% (75.5% with
indexed kuna deposits) of the effective broad
money supply, which would also include foreign currency in circulation. Of course, the
euro changeover did not involve noneuro legacy foreign currencies, so the authors do not
have precise estimates of their stock.7 Survey
based estimates by Stix (2001) suggests that
other currencies, mostly U.S. dollar and to
a lesser extent Swiss franc, comprised about
one-fifth of the total foreign currency cash
stock in Croatia before the changeover. Including this estimate into the total stock of foreign currencies would raise the comprehensive
dollarization rate somewhat further, to 76.7%,
6. The estimate is probably the lower bound as some
residents may have taken their cash stock abroad for the
changeover. For a more detailed discussion see Kraft
(2003).
7. It is possible that some euro-legacy cash was converted into dollars, so that the cash changeover might have
actually somewhat increased the stock of dollars. But the
limited evidence available suggests that this effect was
negligible.
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CONTEMPORARY ECONOMIC POLICY
FIGURE 3
Estimated Stock of Deutschemark and Euro
Currency in Circulation around the Time
of the Euro Cash Changeover
3500
3000
DEM
2500
EUR
HRK
In conclusion, it seems that deep-rooted
lack of confidence in the domestic currency
is at the root of dollarization in Croatia, with
foreign currency remaining the preferred store
of value. Even the Euro introduction did not
change the behavior of economic agents regarding the currency composition of deposits
and the holding of foreign currency cash.
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III. IMPLICATIONS FOR MONETARY POLICY
1000
07.02
06.02
05.02
04.02
03.02
02.02
01.02
12.01
11.01
10.01
09.01
0
08.01
500
Source: Croatian National Bank estimates.
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or about 10 percentage points over the ‘‘conventional’’ dollarization rate.
Study of the dynamics of foreign currency
in circulation around the changeover process
allows the authors to make several further
observations (Figure 3). First, most of the
cash inflows took place during the last couple
of months prior to the changeover, and the
majority of the cash deposited with the banks
remained there even after the conversion. This
suggests that Deutschemark cash served
mostly as a store of value.
Second, it is noteworthy that Croatia had the
largest absolute growth of euro-denominated
deposits during 2001 of all countries outside
the euro-area (European Central Bank 2002).
Third, it seems that some of the restocking
process continued even after the changeover
was over. This additional restocking appears
to have been largely driven by the crises in the
third largest bank in Croatia, Riječka banka.8
Probably the majority of the 500 million euros
cash outflow after the crises would have stayed
in the banks if it had not occurred, further supporting the thesis that foreign currency cash is
to a large extent used as a store of value.9
8. The activities of a rogue trader were uncovered
in March 2002, and a run ensued. Fortunately, the bank
remained solvent and also had enough liquid assets (central bank and Treasury bills) that it was able to weather the
run with support from the central bank and other commercial banks. The owners, who had lost most of their
capital, withdrew from the bank, and the government first
assumed ownership and then quickly sold the bank to
a new strategic investor.
9. About 200 million euros pertain to direct outflows
from Riječka Banka, and aggregate indirect effects on
other banks were probably roughly equal to this figure.
Baliño et al. (1999) conclude that there is
no a priori case for fixed or flexible exchange
rate regime arising simply from the dollarization of the economy. However, they note that
dollarization poses special challenges for the
pursuit of coherent and independent monetary
policy. Dollarization tends to increase volatility of the exchange rate, makes the demand for
domestic money more unstable, and complicates the definition of the relevant monetary
aggregates. In addition, it introduces more risk
into the banking system due to balance sheet
effects and makes the lender of the last function much harder to perform due to the possibility of runs on foreign currency deposits.
In the Croatian case, the authors believe that
the balance sheet effect is the biggest risk and
the main justification for a regime limiting
exchange rate flexibility. For this reason, they
begin the assessment of the implications of
dollarization for monetary policy with balance
sheet effects. After that, the authors consider
the issue of portfolio shifts. Rapid portfolio
shifts may lead to herding, thus making attempts to achieve managed real depreciation
dangerous. Finally, the authors briefly cover
the issue of pass-through of exchange rate
changes to inflation, which they consider to be
a less important problem for Croatian monetary policy.
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Balance Sheet Effects
Some earlier research, despite acknowledging negative effects, emphasized the positive
consequences of dollarization, such as financial deepening or lower borrowing costs, but
recent studies emphasize excessive risk taking
by the banks and resulting financial fragility as
the main negative consequence of liability
dollarization (De Nicoló et al. 2003). In the
event of significant depreciation, currency mismatches can have catastrophic effects, leading
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to a meltdown of the financial system. To minimize exchange rate risk arising from deposit
dollarization and to satisfy prudential regulations, banks often lend in foreign exchange,
transferring the exchange rate risk to their
borrowers. However, such a policy transforms
exchange rate risk into credit risk as borrowers
end up with large unhedged exchange rate
exposures. Croatian banks are no exception
to this rule, because foreign exchange deposits
are a major portion of their funds, as discussed. The overwhelming majority of their
loan portfolio (almost two-thirds) consists
of claims indexed to foreign exchange, reaching almost three-quarters if outright foreign
currency loans are added. Loans in domestic
currency represent only a bit over a quarter
of their loan portfolios. Prudential regulations
limit currency mismatches to 20% of bank’s
liable capital, and indexed assets or liabilities
are counted as foreign exchange in this.
These aggregate data do not allow one to
make strong conclusions about the increases
in defaults that might come about due to a
depreciation. Data from firms’ financial statements suggest that after-tax profits equaled
3.9% of income for medium-sized firms in
2001 on average, and 4.6% of income for
large-sized firms. Interest expenses for the
same groups of firms were 3.2% and 4.1% of
income, respectively. On average, about 70%
of firms’ borrowing is indexed, so that a 1%
depreciation would lead to about a 0.7% increase in interest rate expenses. Following
this logic, a 20% depreciation would increase
interest expense by 14% on average, resulting
in increases of 0.45% and 0.57% of income
for medium and large firms, respectively. Although this would not be enough to cause
default for the average firm, it could endanger a large number of marginal firms. A more
precise estimate would require detailed knowledge of the currency composition of firm borrowing at the firm level and the currency
composition of firm income and expenditures.
Such data are not available. Furthermore, the
knock-on effects of initial defaults on other
firms and banks are quite difficult to model.
This leaves the authors in the uncomfortable
situation of having to guess just how significant the balance sheet effects might be. Their
view is that they could be quite substantial.
According to Krugman (1999), the decision
by an individual firm to borrow in foreign
currency imposes costs on the rest of the econ-
7
omy, because such borrowing magnifies the
real exchange rate impact of adverse shocks.
The policy advice to discourage firms from
taking on debt denominated in foreign currency may sound reasonable, but it does not
change the reality of large unhedged exchange
rate risk within the economy as a whole due
to deposit dollarization. In fact, it would be
imprudent for banks to grant only unindexed
domestic currency loans when a majority of
their liabilities are in foreign exchange. That
is, if deposit dollarization cannot be reversed,
Krugman’s policy advice is irrelevant, because
the foreign exchange liabilities must be
matched somewhere.
Many authors have concluded that the key
policy issue is how to reverse dollarization.
Ize and Powell (2004) emphasize the need to
develop a comprehensive approach to induce
dedollarization. Such an approach may include strategies such as toughening risk assessment for foreign exchange lending, reducing
remuneration on required reserves for foreign
currency deposits, and increasing remuneration on required reserves for domestic currency deposits or other prudential measures
to internalize the social costs of borrowing
in foreign currency.10
However, if dollarization cannot be reversed rapidly, many of those measures would
not help reduce the vulnerability of the financial system. The central bank has, in these
authors’ view, deemed widespread dollarization irreversible. Therefore, the Croatian
National Bank has taken a different path to
avert the nightmare scenario of sharp depreciation and a broad-based balance-sheet meltdown. Regulations in force through the end
of 2002 required banks to hold some 53%
of the value of short-term foreign exchange
deposits with credit-worthy foreign banks. In
2003 this was broadened to all foreign exchange liabilities (although the rate was reduced to 35%, it effectively increased liquidity
requirements). The regulatory system was thus
geared toward reducing the vulnerability and
preparing the system to withstand the blow,
rather than simply attempting to incorporate
social costs into the calculus of portfolio
choice. Croatian banks effectively have to
10. In a related work, Honig (2003) finds that
greater credibility of institutions is associated with
dedollarization.
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CONTEMPORARY ECONOMIC POLICY
keep almost a third of their foreign currency
liabilities in the form of liquid foreign assets,
required foreign currency reserves with the
central bank or deposits with foreign counterparts. Like all prudential measures, these
regulations have costs and may induce disintermediation. This must also be taken into
account when considering the downside of
dollarization.
To use a nautical metaphor, dollarization
reduces the stability of one’s boat. To deal
with this, Croatia has tried to avoid choppy
seas by managing the exchange rate, and it
has required banks to wear large life jackets
(high reserve and liquidity requirements).
Finally, it is important to note that depreciation pressures have actually been very rare
in Croatia. Strong capital inflows have led to
balance of payments surpluses and appreciation pressures. Bofinger and Wollmershaeuser
(2001, 2003) argue that a managed float can be
feasibly sustained in the face of strong capital
inflows, because appreciation pressures can
always be resisted by money creation. The
authors consider that this challenge to the
bipolar view, popularized above all by Fischer
(2001), has considerable merit, as the Croatian
case suggests. However, strong capital inflows
create a different set of problems than the ones
discussed in this section, including loss of competitiveness and sterilization dilemmas. Still,
the greatest risk of crisis, and therefore the
key issue for the design of monetary policy,
does not stem from appreciation pressures
but from the rare depreciation pressures,
which can activate the balance sheet issue.
This will become apparent in the next section,
where the authors discuss the portfolio shifts
that can cause depreciation pressures.
Portfolio Shifts
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585
Baliño et al. (1999) assert that the key implication of dollarization is greater exchange
rate volatility as the public may shift between
domestic and foreign currencies for a number
of not easily identifiable reasons. Vujčić (2003)
refers to such behavior as ‘‘lukewarm capital’’
because changes in the portfolio composition
of the households and corporations can cause
currency attacks or runs on banks. Domestic
residents exhibit elements of herd behavior,
just like foreign investors. However, unlike
foreign inventors, they are numerous and
may react more slowly, although in the face
of stronger depreciation of domestic currency
they may start selling domestic currency. In
addition, if they perceive depreciation to be
an early sign of banking sector problems, as
was the case in Croatia in 1998–99 (see later
discussion), they may withdraw deposits from
the banking system. And a run on foreign exchange deposits can be challenging both for
individual banks and for the system as a whole,
given the limited ability of the central bank to
provide lender of last resort facilities in foreign
currency.
A number of studies in this vein look at the
impact of exchange rate movements, along
with other factors, such as interest rate differentials or default risk, on the currency
structure of domestic agents’ portfolio in different countries (see Ooomes 2003 for Russia;
Kamin and Ericsson 1993 for Argentina;
Mongardini and Mueller 2000 for the Kyrgyz
Republic; Gruben and Welch 1996 for
Mexico). Most of those studies confirm the
significant impact of exchange rate depreciation on demand for the foreign currency
portion of money in dollarized economies.
However, exchange rate appreciation does
notalways induce reversal. Empirical evidence in most of those studies supports some
degree of dollarization persistence.
Kraft (2003) and Vujčić (2003) adopt a similar approach to Croatia. Despite the modest
exchange rate variation during the years since
1993, when inflation was brought under control, both authors are able to model the effect
of exchange rate changes on the behavior of
Croatian residents. Vujčić (2003) concludes
that even a relatively small exchange rate
movement (well within a 10% range) prompts
shifts between domestic and foreign deposits.
Exchange rate movements do not have a significant impact on total deposits, but both domestic and foreign currency deposits declined
after bank failures. Kraft (2003) confirms
these results as he finds that exchange rate
movements do not affect total deposits but
the composition of deposits, controlling for
valuation effects. Depreciation of the domestic currency immediately leads to changes in
the currency portfolio allocation of domestic
economic agents. According to his results,
a 20% depreciation would reduce the share
of local currency deposits in total deposits
by about 24%, or from the sample mean of
13.2% to 10.0%.
590
595
600
605
610
615
620
625
630
635
640
ŠOŠIĆ & KRAFT: FLOATING WITH A LARGE LIFE JACKET
9
FIGURE 4
Kuna Deposits and Total Deposits during the 1998–99 Banking Crisis (million HRK)
Source: Croatian National Bank.
645
650
655
660
665
670
Exchange rate fluctuations in Croatia have
been muted since 1993. Given the strength of
the portfolio shift effects identified here and
in earlier studies, this unresponsiveness may
appear strange. But it may also indicate that
monetary policy was effective in managing
the exchange rate. As economic agents leaned
with the wind, monetary authorities leaned
against the wind, preventing changes in the
composition of agents’ portfolios from turning into a vicious circles of depreciation and
a run on currency.
The only sustained period in which the
central bank was unable to contain depreciation pressures was during the banking crisis
and recession of 1998–99. After the failure of
Dubrovačka Banka in February, the currency
depreciated slowly but steadily (except for the
summer months, when the inflow of foreign
exchange from tourism stabilized the market)
until February 1999, despite numerous central
bank interventions. Depositor behavior was
a key, as deposits in kuna fell steadily from
a peak in August 1998 through May 1999
(see Figure 4). Depositors seemed to link banking sector problems with possible depreciation, which in the end became a self-fulfilling
prophecy. The depreciation came to an end
when the Ministry of Finance succeeded in selling a Eurobond. This brought money into the
country and showed that Croatia still had
access to international capital markets, despite
the Russian crisis abroad and the recession at
home.
A run on the currency and a run on banks
in a dollarized economy can have similar
implications. The withdrawal of foreign exchange deposits from banks is analogous to
capital flight. Such withdrawals should be
recorded in the balance of payments (under
the heading ‘‘other investments/currency and
deposits’’). Such flows exert pressure on the
foreign exchange market and induce macroeconomic disturbances.
Net flows of euro-legacy currencies and
euro notes into the banking system turned
negative on only two occasions during the past
decade: banking crises of 1998–99 and Riječka
Banka crises of early 2002 (see Figure 5), with
the magnitude of net outflows on the latter
occasion surpassing the former, even though
the second crisis was much less severe, probably reflecting growing caution on the part
of agents. This suggests that domestic agents
may be a more serious threat than foreign
investors for capital outflows and current account reversal under adverse conditions, regardless of whether they simply choose to
exit from the domestic currency or take their
deposits out of the banking system.
675
680
685
690
695
700
Pass-Through Effects
To the extent that foreign currency acquires
a means of payment role, or that domesic
currency prices are formally or informally
indexed to the exchange rate, exchange rate
fluctuations may feed strongly into price
705
10
CONTEMPORARY ECONOMIC POLICY
FIGURE 5
Net Flows of Euro and Legacy Currency Cash into the Banking System
Source: Croatian National Bank.
710
715
720
725
730
735
movements. If such a case indeed exists in
Croatia, as casual evidence suggests for some
big-ticket items, it may reinforce the case for
stabilizing exchange rate fluctuations as a main
precondition for the achievement of price
stability.11 However, if price setting is not
indexed to foreign currency, fear of floating
due to strong pass-through effects may be misguided. Shi and Honohan (2002) explore the
link between deposit dollarization and passthrough effects. Their research confirms that
high dollarization strengthens pass-through
effects—an increase of deposit dollarization
by 10 percentage points increases estimated
pass-through by over 6%. This relationship
may be due to the same underlying factors
influencing both deposit dollarization and
pass-through effect, in which case the logic
would be only slightly different, as dollarization may rather represent an indication of
higher pass-through than the cause.
This problem of pass-through from exchange rate to prices in Croatia has been examined in two recent publications. Billmeier
and Bonato (2004) find evidence of passthrough from exchange rate to producer prices
in the short-run using a vector autogressiv,
but no pass-through from the exchange rate
to consumer prices. However, in their longrun analysis using a cointegration approach,
they find that a 10% change in the exchange
11. This argument is made by Coricelli et al. (2004).
rate leads to a 3.3% increase in the retail price
level. They consider that their results do not
confirm ‘‘the widespread indexation of wages
and prices that is generally reported by casual observers’’ but do indicate ‘‘a significant
pass-through in Croatia, higher than in other
countries with a lower degree of dollarization’’
(Billmeier and Bonato 2004, p. 441).
The other paper, by Gattin-Turkalj and
Pufnik (2002), tests a broader range of price
indices, finding that both exchange rate
changes and changes in the world market price
of oil Granger cause changes in Croatian
producer prices. Exchange rate and oil price
changes do not Granger cause changes in
Croatian retail prices, but changes in producer
prices do. The estimated magnitude of the
pass-through is small, with a one-standarddeviation (3.6 percentage points) exchange
rate shock resulting in a 1 percentage point
producer price increase.
The results of these studies of pass-through
effects in Croatia must be taken with caution.
First, the relatively low rate of pass-through
found in the studies may be the very consequence of successful exchange rate stabilization. In other words, it may be endogenous
to the current exchange rate regime and any
significant change to the regime may change
the price-setting behavior of the agents. Second, throughout the observed period many
prices were regulated, which may also reduce
pass-through effects. Third, Taylor (2000)
740
745
750
755
760
765
770
ŠOŠIĆ & KRAFT: FLOATING WITH A LARGE LIFE JACKET
785
790
795
800
805
810
815
820
IV. MONETARY POLICY UNDER THE
CONSTRAINTS OF DOLLARIZATION
Monetary policy in Croatia has been
mainly dictated by the exchange rate regime
and has relied heavily on foreign exchange
intervention to create money and to stabilize
exchange rate fluctuations. As of mid-2005,
foreign assets comprised about 94% of central
bank assets, which is similar to the balancesheet structure of a typical currency board.12
The domestic money supply has always been
fully covered by the central bank’s international reserves (see Figure 6).
Calvo and Mishkin (2003) refer to this type
of flexible exchange rate regime as ‘‘floating
with a large life jacket,’’ where large international reserves provide insurance against
a run on the currency or excessive exchange
rate fluctuations. Large exchange rate volatility is clearly not an option in the Croatian
case, but policy makers obviously have felt
that there are advantages to not tying one’s
own hand by introducing a fixed exchange rate
regime. The policy of flexible exchange rate
regime retains two-way risk in the foreign
exchange market, which helps to discourage
speculative capital inflows. It also allows the
exchange rate to reflect changes in funda12. This ratio had been as high as 99% before the introduction of reverse repo auctions in summer 2005.
CNB's international reserves
8/02
1/02
6/01
4/00
11/00
9/99
7/98
2/99
5/97
12/97
3/96
10/96
1/95
Dollar value of the money supply (M1)
8/95
7,500
6,500
5,500
4,500
3,500
2,500
1,500
500
6/94
780
FIGURE 6
Money Supply and International Reserves
million USD
775
suggests that low inflationary expectations
may by themselves reduce pass-through. In
this interpretation, pass-through is low in part
because inflation fell so rapidly in the first
years after stabilization. Fourth, Campa and
Goldberg (2002) argue that pass-through is
closely related to the commodity composition
of the import basket. Although Croatia is quite
dependent on oil imports, during most of the
period studied, domestic oil prices were closely
regulated, limiting the pass-through effect.
To summarize, on one hand, there is little
evidence that greater exchange rate variation
would result in substantially higher inflation.
But on the other hand, it is somewhat unclear
whether one can extrapolate from the findings
about pass-through in a period when the exchange rate was very closely managed to a hypothetical regime where substantially greater
fluctuations are allowed. The pass-through
argument, then, does not clearly dictate the
exchange rate regime. Instead, the balance
sheet effect has greater persuasiveness.
11
Source: Croatian National Bank.
mentals, although in a limited way (Vujčić,
2003). Simulations by Moron and Winkelreid
(2005) support precisely this nonlinear policy
approach of tolerating small exchange rate
changes but intervening strongly to prevent
large changes. Such a policy creates a degree
of uncertainty that makes speculative behavior less lucrative, mitigating one-way gamble
effects while preventing large changes that
would create large portfolio effects.
The central bank has generally avoided announcing specific exchange rate targets.13 Foreign exchange interventions were mainly used
to prevent the domestic currency from excessive appreciation, providing grounds for the
growth of international reserves. The monetary effect of interventions was often partially
offset to prevent the creation of inflationary
pressures, excessive credit growth, and a widening of the current account deficit. Until recently, the role of administrative instruments,
mostly reserve requirements, was steadily reduced, whereas the Croatian National Bank
increasingly relied on marked-based instruments (auctions of central bank bills to commercial banks) to sterilize the monetary effects
of foreign exchange interventions.
This framework was unable to provide countercyclical policy. Lang and Krznar (2004)
construct an indicator of the monetary policy
stance using a vector autoregressive framework and find that monetary policy tightens
with the recession and eases with the expansion. In essence, this occurs because recession
13. In the years from 1994 to 2002, no targets were
announced. On a few occasions since then, the governor
of the Central Bank has explicitly stated that the bank
would defend an upper bound of 7.7 kuna per euro.
The exchange rate did exceed this figure briefly in early
2004, but quickly returned to the acceptable range.
825
830
835
840
845
850
855
12
860
865
870
875
880
CONTEMPORARY ECONOMIC POLICY
in Croatia in 1998–99 was associated with
bank failures, lukewarm capital flows, and depreciation pressure. Monetary policy worked
to stabilize the exchange rate in 1998–99,
tightening the money supply, because this
was deemed the best way to restore confidence. Furthermore, exchange rate depreciation in and of itself created higher borrowing
costs for all those borrowers with indexed
loans, so stabilizing the exchange rate actually
implied stabilizing effective interest rates.
Lang and Krznar’s finding is in accordance
with Mishkin’s (1996) view on the priorities of
the monetary policy in dollarized economies—
monetary policy that is not aligned with the
cyclical position of an economy may only
cause minor damage compared to the consequences of financial meltdown. The procyclicality of monetary policy in Croatia is also in
harmony with the findings of Kaminsky et al.
(2004), who find procyclical monetary policy
to be a widespread phenomenon in developing
countries. Though further research is needed
on other cases, the Croatian case suggests that
procyclicality may be a lesser evil than other
policy options given the reality of dollarization.
V. LOOKING FORWARD
885
890
895
900
905
Although Croatia’s monetary policy regime
has arguably been adequate to meet the challenges of maintaining low inflation, handling
the macro effects of bank crisis and managing
lukewarm capital, major tests can be expected
in the future. As indicated, capital flows pose
key challenge to the monetary policy in
Croatia. Even a partial step toward the liberalization of foreign exchange regulations in
2001 made the monetary authorities nervous
about shifts in the currency structure of enterprise deposits. In an environment of high and
persistent liability dollarization, domestic residents can augment the usual capital flows and
magnify the impact of a sudden stop on the
economy. Large international reserves have
not been needed to avert financial crises so far,
but in case of serious run on banks or currency,
even a very large life jacket may prove to be
insufficient.
The National Strategy for the Accession
of Croatia to the EU (Ministry of European
Integration 2004) has envisaged full liberalization of the capital account by 2006. This
decision was made even though Croatia will
probably enter the EU before its obligation
to liberalize its capital accounts, deriving from
the Stabilization and Association Agreement
signed in 2001 but only ratified in 2005, comes
into force in 2009. This means that full capital
account liberalization can be postponed if
necessary.
However, Croatia has signed numerous
bilateral treaties that preclude any restrictions
on foreign investment in most securities, and
the Central Bank waived restrictions on the
remaining countries in March 2005. The only
substantial restriction remaining is on participation in the primary market for government
securities, and in light of the large presence of
foreign banks in Croatia, this restriction does
not seem very onerous. Furthermore, under
the terms of the Stabilization and Association
Agreement, Croatia may only impose capital
controls for a period of six months; extension
for another six months requires parliamentary
approval, which would presumably be very
difficult to obtain.
In other words, capital account liberalization is already far advanced. Some have argued that the danger of sudden stops in
accession countries is so bad as to make early
adoption of the euro the wisest policy (Buiter
2004; Begg et al. 2001). It is perhaps true that
Croatian adoption of the euro may not necessarily satisfy the traditional optimal currency
area criteria, because Croatia still has a rigid
labor market and business cycle that is not
highly synchronized with the euro area’s cycle.
Nonetheless, adoption of the euro would remove almost all the currency mismatches from
banks balance sheets and thus reduce the high
potential costs of a sudden stop.
However, the early introduction of the euro
is precluded by the Maastricht Treaty and is
simply not on the table. Instead, Croatia will
have to follow the same steps that other EU
members have taken to adopt the Euro. And
although accession to the EU and ERM-2
may change the formal exchange rate regime,
in particular by introducing explicit exchange
rate bands, without much more substantial
decreases in dollarization, it is hard to expect
a substantive change in the nature of the regime.
Moving to a harder peg would not really help;
it would not eliminate currency mismatches,
and it would do away with the ability to use
nominal exchange rate change as a shock absorber. Croatia will just have to rely on its
large life jacket until it can reach the dry land
of euro adoption.
910
915
920
925
930
935
940
945
950
955
960
ŠOŠIĆ & KRAFT: FLOATING WITH A LARGE LIFE JACKET
13
APPENDIX A: DOLLARIZATION LEVELS BY BROAD REGIONAL GROUPS
APPENDIX FIGURE A1
Foreign Currency Deposits as a Share of Broad Money
70,0
60,0
1993
1998
50,0
40,0
30,0
20,0
10,0
0,0
Croatia
Transition
Middle East and Asia South America
Central America
and Caribbean
Note: To facilitate comparability, countries with GDP/capita at PPP of less than 1/2 of Croatia’s in 1998
($6698) were excluded.
Source: Shi and Honohan (2002).
965
Groups: Transition: Belarus, Bulgaria, Czech Republic,
Estonia, Georgia, Hungary, Latvia, Lithuania, Macedonia
FYR, Poland, Romania, Russia, and Slovakia. Middle
East and Asia: Lebanon, Philippines, Saudi Arabia, and
Turkey. South America: Argentina, Paraguay, Peru,
Uruguay, and Venezuela. Central America and Caribbean: 970
Costa Rica, El Salvador, Jamaica, Mexico, and Trinidad
and Tobago.
APPENDIX B: BANKING SECTOR AND MONETARY DEPTH IN DOLLARIZED ECONOMIES
APPENDIX FIGURE B1
Banking Sector Assets/GDP
120,0
100,0
1994
1998
2003
80,0
60,0
40,0
20,0
0,0
Croatia
European transition Middle East and
Asia
countries
Source: IMF, International Financial Statistics.
South America
Central America
and Caribbean
14
CONTEMPORARY ECONOMIC POLICY
APPENDIX FIGURE B2
Money Plus Quasi-Money/GDP
70,0
60,0
1994
1998
50,0
2003
40,0
30,0
20,0
10,0
0,0
Croatia
European transition Middle East and
Asia
countries
South America
Central America
and Caribbean
Source: IMF, International Financial Statistics.
Country groups are the same as in Appendix A.
975
980
985
990
995
1000
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