12 November 2007

Private debt overshadows Goldilocks scenario

By Eric Jansson
Published by Financial Times, 12 November 2007

Working papers from the International Monetary Fund usually make dry reading. But one such paper has caused a splash in Croatia, as campaigning kicks off in advance of the country's November 25 parliamentary election.
The IMF paper titled "Vulnerabilities in Emerging South-eastern Europe - How Much Cause for Concern?" published last month, argued that south-east Europe had begun to show imbalances similar to those seen in East Asia before financial crisis struck a decade ago.
In a tone more prescriptive than accusatory, the authors refrained from criticising individual governments in the region, which has experienced some of Europe's swiftest economic growth in recent years. Nonetheless, they highlighted acute imbalances in Croatia, which has a higher debt level as a percentage of GDP, and a higher current account deficit, than the East Asian average before that region's 1997 crisis, despite achieving slower GDP growth, 4.8 per cent in 2006.
With the highest external-debt-to-GDP ratio of any non-EU country in Europe and the greatest exposure to foreign currency loans, Croatia faces a growing risk of financial hiccups, the authors wrote: "The probability of a sudden stop increased between 2000 and 2006, especially in Croatia and Serbia. The probabilities are driven by the rising degree of euro-isation and the extent to which tradable consumption is 'financed' from abroad."
Ivo Sanader, the prime minister, and his finance minister, Ivan Suker, quickly brushed the critique aside. "There is no financial crisis. Croatia is servicing its debts," Mr Sanader said.
But the paper's assertions provide fresh ammunition to Croatia's main opposition party, the Social Democratic Party (SDP), which has made similar concerns central to its election campaign. Economic mismanagement under Mr Sanader's Croatian Democratic Union (HDZ) has threatened economic stability, Social Democrats say.
Ljubo Jurcic, the SDP's prime ministerial candidate and chief economic strategist, argues that Croatia's economy has immense capacity for growth, but that it has been wrongly managed. Citizens have grown accustomed to an inflated standard of living "based on household debt", he says.
The dispute sets Croatia on course for an election focused closely on economic issues.
Mr Sanader's government has done much to bring Croatia more securely under the wing of the EU, with which the country began accession negotiations in 2005. He and his cabinet ministers describe their economic reform programme within the broad context of EU accession, emphasising a need to harmonise legislation with the acquis communautaire , the vast body of EU law. The HDZ portrays any challenge to this course as a potential risk to EU entry, which the Sanader government until recently promised could be achieved by 2009.
Yet the IMF paper warns against such approaches, asserting that the "EU halo effect" lowers perceived risk, sometimes unjustifiably.
The HDZ supports central bank measures aimed at limiting commercial credit growth. Its programme also includes paying down external debt, and the government has taken steps in this direction during the past year. Yet government claims that Croatia's external debt is shrinking exclude private-sector debt. Overall external debt rose from 30 per cent of GDP 10 years ago to 85 per cent last year. Central bankers predict it will rise to 86 per cent this year.
"External vulnerabilities have begun to appear and to create risks for stability," says Ljubinko Jankov, executive director of research and statistics at the Croatian National Bank, the central bank.
With financial markets experiencing a higher than usual degree of unpredictability amid a global "credit crunch", economists have begun focusing with new keenness on the price of borrowing, especially as Croatia has a growing share of short-term debts, which magnifies rollover risk.
"If there is a big global shock, it is for sure going to be a big problem for this whole region, including Croatia," Mr Jankov says.
Economists at Zagreb's European-owned banks continue to offer upbeat assessments, noting steady GDP growth, low inflation and the central bank's strict regulation of credit growth.
"Looking at credit default swap spreads there is no evidence of concern from investors and I, for a change, actually agree with Mr Suker that the current situation is stable," says Goran Saravanja, chief economist at Zagrebacka Banka, owned by Italy's UniCredit Group.
Mr Saravanja says both the SDP-led coalition that governed from 2000 until 2003, and the current HDZ government, pursued credible courses of economic reform after a decade of authoritarian rule.
The current government showed a willingness to tackle sensitive economic issues when it re-indexed pensions. Recent reforms won praise from the World Bank, which called Croatia the world's second best reformer for last year in its Doing Business 2008 report. Next year ministers must tackle economic restructuring at the state-owned shipyards and elsewhere.
Croatia is now entering an "interesting" phase, says Mr Saravanja. "We have to see how post-2000 Croatian economic policy stands up to a downturn in the economic cycle, and we have not seen that yet."
Beneath the debate over financial risk, other economic fundamentals may be at issue in the upcoming election. Mr Jurcic, though representing the traditionally centre-left Social Democrats, sometimes casts these in terms of "free market competition". He speaks of "preparing the atmosphere for tax cuts", including a 50 per cent cut on health care contributions.
Mr Jurcic's message that small businesses should be able to operate on terms equal to those enjoyed by the country's big companies strikes a chord with citizens who still feel cheated by Croatia's "tycoonisation", the local term for corrupt privatisation in the early post-communist period.
The HDZ is vulnerable to criticism from this angle, says Joel Anand Samy of the Adriatic Institute, a free-market thinktank. "In Croatia, crony capitalism is flourishing but not entrepreneurial capitalism, and it frustrates people," he says.
Damir Polancec, the deputy prime minister and HDZ candidate, suggests such criticism is overblown and that economic results speak for themselves, with GDP growth up to 6 per cent in the first half of this year. "A few years ago, one would become an entrepreneur because there was no alternative. Today, people are coming because of ideas, coming up with their own projects," he says.
In fact, few analysts expect significant policy changes after the elections, whoever wins. Mr Jurcic embraces some free market ideas, arguing that unproductive companies should have support withheld, and calling for a liberalised labour market. But he also praises former Yugoslav industrial performance and says that aggressive reforms are "politically impossible" in Croatia. Parts of the SDP's programme still carry a whiff of central planning, such as a plan to set up advisory "project teams" for industry.
Polls suggest voters are evenly split. Many have come to realise that with EU accession dominating the country's agenda, a new government led by either main party may struggle to leave an individualised mark on economic policy.

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