The Croatian National Bank lowered its discount rate for the first time in more than four years, to 3.0%, while it dropped its lombard rate for the first time in nearly two years, to 2.5%. The moves are all a part of the Bank's efforts to manage liquidity and exchange rates as the Croatian banking system converts their Swiss-franc denominated loans to euro-backed ones. Click through for more analysis and data.
IHS perspective | |
Significance | Yesterday (20 October), the Croatian National Bank (HNB) made a rare move and slashed its lombard and discount rates to 2.5% and 3.0%, respectively, in order to relieve pressure on the kuna. |
Implications | The HNB has had to be much more active than normal in providing kuna and euro liquidity for the country's forced conversion of Swiss-franc denominated loans to euro-denominated ones. |
Outlook | IHS does not believe that these moves will be the last ones taken by the bank to manage liquidity demands through the end of 2015. Last week, the HNB governor promised more interventions to keep the kuna in line and to make sure liquidity is sufficient for the switch. |
In a rare move, the Croatian National Bank (HNB) moved its lombard and discount rates yesterday (20 October) in an effort to relieve pressure on interest rates and the kuna. The discount rate was slashed from 7.0% – where it had been since June 2011 – to 3.0% while the lombard rate dropped from 5.0% – steady since December 2013 – to 2.5%. In a statement alongside the moves, the HNB said that the cuts are an effort to secure enough liquidity in the banking system and to keep the kuna stable. In its press release, the bank stated that demand for kuna liquidity is rising because of the HNB's forced conversion of Swiss franc loans into euro-denominated ones. The bank has also lowered short-term liquidity loan rates, with three-month loans dropping from 5.5% to 3.5% and the rate on those longer than three months dropping from 6.0% to 4.0%.
The lowered interest rates are surprising, but not without warning. The central bank's forced conversion impacts approximately HRK25 billion in Swiss-franc denominated loans that must be converted into euro before mid-November. At the outset, the bank estimated that its reserves could drop by close to EUR1 billion due to the conversion and shifting currency demands. The local banks are footing the bill for the scheme, with the total cost estimated at around HRK8.5 billion – equivalent to around three years of financial sector profits. While the bank must ensure that kuna liquidity is sufficient for the changeover, the move from the franc loans to euro loans does drive demand for the single currency, which puts pressure on the kuna-euro rate. Last week, HNB Governor Boris Vujcic warned that the Bank would need to intervene again in the local foreign exchange market in November or December in order to provide enough euros for the conversion, thus keeping the kuna-euro exchange rate in check. Already, in September, the bank had intervened with a total EUR268 million to support the kuna. The HNB manages the float of the kuna against the euro within a band ranging from 5% to -5%. The costly conversion plan was undertaken by the government to protect the debt-servicing burden on Croatian households immediately before parliamentary elections are held on 8 November. Without some actions, the freeing of the Swiss franc imposed much greater kuna servicing obligations on Croatian debtors.
Outlook and implications
The conversion scheme fell afoul of European Union standards. The move was imposed unilaterally and is facing stiff resistance from the predominantly foreign-dominated financial system. Several banks have appealed the case to constitutional court. The actions severely damage Croatia's investment standing. Even if the plan proceeds without the courts freezing further actions, the government is struggling to manage the side-effects of the scheme. We expect that these moves and interventions to date will not be the last for the HNB as more and more loans are converted ahead of the deadline. As promised by the banks, the reserve drawdown will be severe in order to provide enough liquidity for the switchover.
While the damage to stability and to reputation is widespread, the benefits are questionable. Although the forced conversion does free up some liquidity in Croatian households and businesses that had faced increasingly onerous franc-denominated repayment obligations, now, these costs are being borne by the banking system. In turn, the banks are curtailing their operations as they suffer the losses. With the banks less active, household and business activity are naturally less dynamic because of a lack of or a higher cost on new loans. In all, IHS is projecting sustained, weak domestic demand into 2016, partly due to curtailed banking activity.
Elsewhere, the government is also failing to adhere to European Union standards by continuing to run fiscal deficits that exceed EU limits. As part of the European Union's Excessive Deficit Procedure (EDP), the government reported its 2015 estimated budget deficit to be 4.8% of GDP, well above the 3%-of-GDP threshold. The country has posted fiscal deficits of well over 3% of GDP since 2009. IHS does not forecast this level to be reached again until 2019 at best. As part of the EDP, the government should be obligated to more drastic spending cuts to bring the deficit into line more quickly. However, the government apparently is willing to suffer the ramifications of failing to meet these obligations, as there is little political will for any significant fiscal consolidation. EU transfers going forward may be curtailed should Croatia remain in violation of the EDP.