The Impact of Financial Crisis and Policy

Response in Croatia

Nikola Bokan, Lovorka Grgurić, Ivo Krznar, Maroje Lang

15th Dubrovnik Economic ConferenceJune 2009

Outline

1. Motivation2. Model structure3. Simulation exercise4. Comparison with the actual developments5. Conclusion

1 Motivation

Aim : Understand the impact of the current financial crisis on

Croatia and possible monetary policy response

Method : Unprecedented shocks prevents us to use standard

statistics Testing a newly built model in a challenging situation

2. Model – introductory remarks

Small open economy DSGE model Built with a purpose to analyze different possible

shocks facing Croatian economy Contains large number of possible shocks Calibrated and not estimated

Different from standard IT model due to different monetary policy regime Stable exchange rate, heavy use of regulations (RR) Monetary policy works through banking sector Financial eurisation

Interest in financial variables (credit, debt)

Model structure

Monetary policy in the model

1. Stable exchange rate (random walk)2. Reserve requirement as monetary policy

instrument

• Discretionary monetary policy

High regulatory cost(defined as “immobilized” assets / total liabilities)

3. Simulation exercise

Current financial crisis simulated as an external shock to Croatian economy

1. Increase in price of foreign borrowings (3 pp)2. Drop in exports (10 %)

Impulse responses

Foreign interest rate shock

increase in foreign interest rates: cost of foreign borrowing increases for both banks and firms domestic interest rates increase even more due to RR

real sector: increase in debt/service & production cost decrease in demand (consumption) => decrease in production

& imports financial sector:

decrease in credit demand (HH and firms) decrease in foreign borrowing

Export demand shock

decrease in exports lowers domestic production and household income

real sector: decrease in demand (consumption) => decrease in

production & imports financial sector:

decrease in credit demand (HH and firms) decrease in foreign borrowing

Monetary policy response

Limited room for maneuver Exchange rate depreciation would increase debt service

cost and bad loans due to eurization (not fully modeled)

Monetary authorities can decrease regulatory cost (RR) Simulation of 10 pp decrease in RR

Reserve requirement reduction

1. Decrease in regulatory cost Decrease in domestic interest rates Some increase in real economic activity due to lower

interest rate (consumption, production, imports)

2. Release of previously immobilized assets Significant decrease in foreign borrowing

Banks can't lend all released assets domestically

Combined effect of three shocks

Monetary easing through RR only marginally reduces negative impact of the crisis on real sector

Net exports improve (imports decrease more than exports)

Interest rate increases significantly Credit activity decreases Significant reduction in foreign borrowing

4. Comparison with the actual developments

Early dana showing initial impact of the crisis are available

Model predicted:Slowdown in real activity

-8

-6

-4

-2

0

2

4

6

8

2004:1 2005:1 2006:1 2007:1 2008:1 2009:1(f)

GDPConsumption

%GDP and Personal Consumption (annual rate of change YoY)

Improvement in trade balance

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2005:1 2006:1 2007:1 2008:1 2009:1

Exports (trend)Imports (trend)

EU

R m

illio

n

Merchandise Trade

Decrease in credit activity

0

4

8

12

16

20

24

28

2005:1 2006:1 2007:1 2008:1 2009:1

Credits to private sector (trend)Broad money (trend)

%

Monetary Aggregates(trend, annual rate of change YoY, constant exchange rate)

However:Domestic interest rates increased

moderately

5.0

6.0

7.0

8.0

9.0

10.0

11.0

2004:1 2005:1 2006:1 2007:1 2008:1 2009:1

Households (long term fx indexed)Enterprises (short term kuna loans)

%

Interest rates on loans to private sector

Reasons for moderate increase in domestic interest rates

1. Impact of shock might be exaggerated in simulation

1. Decreased faster than assumed by the model2. Foreign borrowing by banks/firms actually

cheaper/postponed

2. Reduction in RR contributed to less interest rate increase

3. Popular pressures against interest rates increase and already high bank profits

evidence of credit-rationing instead

1

2

3

4

5

6

7

8

9

2004:1 2005:1 2006:1 2007:1 2008:1 2009:1

HR DECEE1 (PL,SI,SK) CEE2 (HU,RO)

%

Yield to maturity of government bonds (in percentage points)

Foreign borrowing continued (although somewhat slower than before)

4,000

8,000

12,000

16,000

20,000

24,000

28,000

2004:1 2005:1 2006:1 2007:1 2008:1 2009:1

Commercial banksEnterprises

EU

R m

illio

nForeign Debt

Reason why foreign borrowing slowed only marginally

GOVERNMENT BORROWING

Banks lent to the government as fiscal revenues dropped

5. Conclusion

The results to a large extent match the actual data showing the early impact of the crisis model is a useful policy analysis tool

With stable exchange rate regime, decreasing the regulatory burden can only marginally reduce the negative impact of the current crisis on real economy