The Impact of Financial Crisis and Policy Response in Croatia Nikola Bokan, Lovorka Grgurić, Ivo Krznar, Maroje Lang 15th Dubrovnik Economic Conference June 2009

Outline 1. Motivation 2. Model structure 3. Simulation exercise 4. Comparison with the actual developments 5. 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  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

Improvement in trade balance

Decrease in credit activity

However: Domestic interest rates increased moderately

Reasons for moderate increase in domestic interest rates 1. Impact of shock might be exaggerated in simulation 1. Decreased faster than assumed by the model 2. 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

Foreign borrowing continued (although somewhat slower than before)

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