VZCZCXRO6732
RR RUEHAG RUEHDA RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA RUEHLN RUEHLZ
RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHVB #0541/01 1171405
ZNR UUUUU ZZH
R 271405Z APR 06
FM AMEMBASSY ZAGREB
TO RUEHC/SECSTATE WASHDC 6082
INFO RUEHZL/EUROPEAN POLITICAL COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/DEPT OF COMMERCE WASHDC

UNCLAS SECTION 01 OF 02 ZAGREB 000541 
 
SIPDIS 
 
SENSITIVE 
 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EINV HR
SUBJECT: CROATIA FOREIGN DEBT WORRIES CENTRAL BANK, 
BUT OTHERS UNCONCERNED 
 
 
SENSITIVE BUT UNCLASSIFIED; PLEASE HANDLE 
ACCORDINGLY. 
 
¶1.  (SBU) Summary:  Croatia's foreign debt as a 
percentage of GDP reached 82.4 percent at the end of 
2005 and has continued to climb in the first quarter 
of 2006, with some analysts predicting it could 
reach 86 percent of GDP by year's end.  This 
seemingly insatiable appetite for foreign borrowing, 
led by Croatia's mostly foreign-owned banks, has 
come despite a decreased reliance on foreign credit 
to finance the state's budget shortfalls and 
draconian reserve requirements enacted by the 
Croatian National Bank.  However, although many in 
Zagreb's financial community have expressed concern 
over such high levels of foreign debt, few believe 
that the country is headed for a debt crisis. 
Although large in its aggregate, the structure of 
Croatia's foreign debt is more favorable than in 
many countries that have experienced debt crises. 
With most liabilities long-term and strong foreign 
reserves, analysts here believe Croatia is in a 
relatively good position to service its debt, 
barring an external shock.  End Summary. 
 
Credit Boom Increases Foreign Debt 
---------------------------------- 
 
¶2.  (SBU) The Croatian economy has experienced a 
credit boom in recent years, led by pent up demand 
for imported consumer goods and a mostly foreign- 
owned banking sector competing for market share. 
The banks, over ninety-three percent of which are 
under foreign ownership (mostly Austrian and 
Italian), have now replaced the state in their share 
of Croatia's overall foreign debt.  Out of a total 
foreign debt of 26.2 billion euros - a stunning 82.4 
percent of GDP - banks now account for 38 percent, 
as opposed to the state's 26.2 percent.  The 
remaining 35.8 percent reflects private sector debt. 
The banking sector in Croatia has been enormously 
profitable in recent years, with interest rates 
several points over the average in the euro-zone. 
This has encouraged banks operating in Croatia to 
increase inflows of lending capital from their home 
offices abroad, which is then used primarily to fund 
consumer lending, particularly mortgages and auto 
loans. 
 
Central Bank Reaction 
--------------------- 
 
¶3.  (SBU) The Croatian National Bank has attempted 
with limited success so far to temper this credit 
boom by imposing increasingly draconian reserve 
requirements on bank capital from abroad.  In 
December of 2005, the Bank raised these requirements 
to 55 percent after previous measures failed to slow 
credit growth.  Damir Bronic, risk manager for 
Austrian Erste Bank in Zagreb told us that the 
current rates are likely to bring the results the 
Central Bank has sought, as the commercial banks 
cannot lend profitably with such a high reserve 
requirement.  Bronic said the banks are now faced 
with a choice between lending at a loss to increase 
market share or attempting to attract new domestic 
deposits.  He predicted that most would opt for the 
latter option, although initial figures for the 
first quarter of 2006 still show strong credit 
growth in the banking sector, so the effect of the 
Bank's measures are yet to be seen.  Many Croatian 
economists are concerned that so much lending is 
directed at consumption, rather than business 
investment.  However, measures that increase the 
cost of money will also increase the cost of 
investment and could have negative consequences for 
employment and overall economic growth. 
 
Debt High But Manageable 
------------------------ 
 
¶4.  (SBU) Apart from some academics, few in Zagreb's 
financial community appear overly concerned about 
Croatia's ability to service its debt.  They point 
to several reasons for this.  First is the fact that 
the structure of Croatia's debt is generally 
favorable.  Most of the debt is long-term, avoiding 
a sudden balloon repayment scenario that would leave 
 
ZAGREB 00000541  002 OF 002 
 
 
lenders running for the exits.  Furthermore, since 
the banks are borrowing from their home offices, 
they have wide latitude to restructure debt.  Second 
is the fact that Croatia has relatively high levels 
of foreign reserves, driven both by tourism and 
foreign investment.  Croatia's foreign reserves are 
over 6.5 billion euros, the equivalent of 
approximately 5 months of imports.  Finally, 
Croatia's banking sector, although foreign owned, is 
operating in Croatia, making it unlikely that the 
parent banks would jeopardize their operations in 
the country. 
 
Kuna Strong Despite Debt 
------------------------ 
 
¶5.  (SBU) One of the peculiarities of Croatia's 
circumstances is the fact that the national 
currency, the kuna, has had a tendency to appreciate 
despite the high levels of debt and a ballooning 
trade deficit.  IMF Zagreb Rep Athanasios Vamvakidis 
points out that this is partially due to the fact 
that Croatia's economy is so tightly linked to the 
economies of the euro zone.  Tourism (which accounts 
for about 20 percent of Croatia's GDP), investment 
and the increasing inflow of pre-accession funds 
from the European Union all put upward pressure on 
the kuna.  So far, the Central Bank has so far been 
able to keep a stable exchange rate against the euro 
through periodic market intervention.  Maintenance 
of the exchange rate is critical for Croatia, as the 
vast majority of consumer debt is linked to the 
exchange rate, so that any significant fall in the 
value of the kuna could have catastrophic 
consequences for debtors whose income is in kunas. 
The relatively high value of the kuna, however, has 
also been a curse for the Croatian economy, as it 
has fueled demand for imports and is a factor in 
making many Croatian exports relatively 
uncompetitive. 
 
External Crisis Wild Card 
------------------------- 
 
¶6.  (SBU) That Croatia's foreign debt and indeed its 
economic growth are sustainable in the near term is 
generally accepted in the financial community here. 
However, there are a number of external wildcards 
that could have significant consequences for 
Croatia.  Velimir Sonje, an economic analyst who 
consults for Erste Bank told us that sustained high 
oil prices could worsen Croatia's economic picture 
and the government's fiscal balance.  The GOC, in an 
effort to soften the impact of rising gas prices on 
Croatian motorists and businesses is now considering 
reductions in the excise tax on fuel to head off 
even sharper price increases.  While welcome for 
motorists, this loss of revenue could make it more 
difficult for the government to meet deficit targets 
and force the state to resort to borrowing to cover 
these gaps.  Perhaps more worrisome, however, is the 
prospect of sharp rises in interest rates in the 
euro zone.  If high energy prices trigger inflation 
in the euro zone and lead the ECB to raise rates 
sharply, these rate hikes would have a direct impact 
on Croatia, not only by increasing the price of new 
borrowing, but also by increasing the cost of some 
debt service.  The result of this could be a 
contraction in credit on the domestic market that 
not only would dampen business investment, but would 
also dampen consumer spending, which has been one of 
the main drivers of Croatia's GDP growth in the last 
several years. 
 
FRANK