Monetary policy under dollarisation: the case of Croatia.

Kraft, Evan

INTRODUCTION

The development of monetary policy in Croatia has taken place under a relatively unusual set of circumstances. War and establishment of a new country combined with transition to a market economy in the early 1990s. The country also faced a legacy of high inflation and a high level of dollarisation. Despite this, Croatia was able to stabilise inflation in October 1993, and has maintained single-digit inflation since then.

This paper will focus on the implications of high levels of dollarisation on monetary policy. I provide evidence that the level of dollarisation, which was high when Croatia became an independent country, has not significantly decreased since, despite successful stabilisation and rapid development of the banking system. Furthermore, thanks to the Euro conversion process, we now have fairly reliable estimates of the amount of foreign currency banknotes circulating in Croatia. These estimates show that the quantity of such banknotes was far greater than the quantity of domestic currency in circulation.

This high level of dollarisation strongly limits the prudent degree of exchange rate flexibility. Limited exchange rate flexibility in turn limits monetary policy's ability to achieve any objectives other than price stability. First, due to balance sheet currency mismatches in the banking sector and the resulting practice of indexing credits to the exchange rate, exchange rate fluctuations have the potential to create credit quality shocks. These shocks could severely impair bank soundness and real activity in the case of substantial currency depreciation.

Second, exchange rate fluctuations may cause changes in the composition of total savings. A large depreciation would risk a flight from the kuna, with strong destabilising effects. Third, exchange rate changes can pass-through to prices, although here I provide evidence that the pass-through is strongest between exchange rates and producer prices, and is actually softened by greater exchange rate volatility.

Given the limits of exchange rate flexibility, one can ask whether an independent monetary policy makes sense at all. Some authors have in fact argued for an early adoption of the Euro. I argue that, at this point, early adoption of the Euro seems a very mixed bag. Its main attraction, lower inflation, is not especially relevant for Croatia. Its costs in terms of loss of lender of last reserve functions, loss of the ability to trade off between exchange rate changes and price level changes, and loss of seignorage would not be entirely negligible.

The other major alternative, inflation targeting, would require tight exchange rate management, at least at the beginning. Thus inflation targeting, while perhaps a somewhat more attractive option than euroisation, would not initially represent a major change. In some ways, therefore, it seems that a 'if it ain't broke, don't fix it' attitude is appropriate.

The paper is structured as follows. The next section provides a background on Croatia's monetary history. The subsequent section analyses empirical aspects of dollarisation and its expression in monetary policy. The last section discusses policy alternatives.

BACKGROUND

In the early 1990s, Croatia faced a situation of war and inherited macroeconomic instability. Output fell 36% from 1990 to 1993, and inflation reached as high as 1616% in 1993 (monthly inflation rates over 35% were common). Importantly, Croatia started with essentially zero international reserves, since the National Bank of Yugoslavia held all of the former country's international reserves and imposed surrender requirements on commercial banks receiving household fx deposits.

Croatia introduced its own currency, the Croatian dinar, in December 1991. This move was the first step in distancing Croatia from the monetary instability generated by the National Bank of Yugoslavia. However, throughout 1992 and most of 1993, inflation remained very high and the exchange rate depreciated rapidly in nominal terms, as the central bank took first steps to overhaul the monetary policy set-up. Direct credits from the central bank to agriculture were abolished, and interest rates were liberalised. The international reserves of the CNB grew rapidly, as low economic activity and considerable trade restrictions carried over from the former Yugoslavia limited imports.

These changes in the monetary policy framework, along with some fiscal consolidation, including pricing of public services and energy to end the losses of large state enterprises, paved the way for the stabilisation programme in October 1993. The stabilisation programme could be loosely characterised as exchange rate based. The key element in the programme was the introduction of current account convertibility, which gave citizens the prospect of eventually turning any local currency to foreign currency. This greatly increased the demand for local currency. In addition, the foreign exchange market was liberalised, allowing banks to freely set their exchange rates. These moves led to a sharp nominal appreciation that squelched inflationary expectations, since households had significant holdings of foreign exchange and were willing to purchase local currency when the exchange rate firmed. Inflationary expectations, it is important to note, had been closely tied to exchange rate depreciation. This was true for a number of reasons: first, most citizens held their wealth as much as possible in foreign currency; second, contracts became widely indexed to fx in the high inflation period; third, data on exchange rates were of course more widely available, more timely and more reliable than data on inflation.

The stabilisation programme contained some mild heterodox elements such as wage controls in public enterprises. However, for the later evolution of monetary policy, the key part of the story is the role of the fx market and the exchange rate in the stabilisation.

In the years 1994-1997, inflation stayed below 3.6% and real GDP grew in excess of 5% each year. At the same time, monetary aggregates grew very rapidly, not only in the first year after stabilisation, but throughout the whole period. Capital inflows built up, in the 1995-1997 period largely due to Croatian citizens bringing money deposited abroad back to Croatia ('repatriation of deposits') and in 1997 in particular due to increased foreign borrowing by Croatian banks. (Croatia received an investment grade credit rating from two of the main ratings agencies in January 1997.)

However, during the end of this period pressures built up, which would later lead to substantial problems. Driven by growing incomes and rapidly growing lending, consumption boomed and imports rose sharply. At the same time, exports failed to keep pace, in part due to slow restructuring and problems with the privatisation model along with political barriers to the EU accession process and regional and multilateral free trade arrangements. The current account deficit ballooned to 11.6% of GDP in 1997. Even though onetime effects were partly to blame, such a deficit was clearly unsustainable.

At the same time, rapid credit expansion was accompanied by excessive risk taking and insider lending (Kraft, 1999; Jankov, 2000; Skreb and Kraft, 2002). This would lead to a wave of bank failures in 1998 and 1999. In combination with measures to combat the current account deficit, in particular Chilean-style capital controls, the banking crisis led to a recession that began in the fourth quarter of 1998 and continued through the third quarter of 1999.

An important phenomenon during the banking crisis and early phases of the recession was a slow, but steady nominal depreciation of the kuna vis-a-vis the deutschemark. When confidence in the banking system fell, Croatian savers moved to foreign currency. The National Bank intervened extensively to limit the depreciation, but generally was unable to prevent it. The steady depreciation extended from April 1998 through February 1999, with a break for the summer months, when tourist revenues buoyed the exchange rate.

Economic growth returned in the fourth quarter of 1999. Political changes in the first quarter of 2000 led to a new environment as the new government embarked on a programme of fiscal consolidation. This allowed more manoeuvering room for monetary policy. In addition, the new government systematically identified and repaid the very large amount of arrears (about 9.6 billion HRK) left by their predecessors. (2) This step greatly increased financial discipline throughout the economy, and provided a one-off boost to enterprise liquidity.

Real GDP grew 2.9% in 2000 and 3.8% in 2001. Monetary aggregates again began to grow rapidly, even before the Euro effect. Headline inflation grew substantially in 2000, in part due to increases in indirect taxes and government-controlled prices. It remained high in the first half of 2001, and then dropped substantially as oil prices fell and administrative price shocks decreased. Throughout the whole period, core inflation was significantly lower than headline inflation, suggesting that demand pressures were not the main cause of price increases.

EMPIRICAL ANALYSIS OF MONETARY POLICY AND MONETARY DEVELOPMENTS IN CROATIA

Dollarisation/euroisation

The level of dollarisation in Croatia was very high under former Yugoslavia, and has not decreased very much in recent years, despite successful stabilisation. Figure 1 shows two definitions of deposit dollarisation. One takes into account the stock of fx deposits in existence in mid-1991, when the National Bank of Yugoslavia expelled Croatia from the Yugoslav monetary system and effectively removed the fx cover for Croatian banks' fx deposits. The Croatian government froze these deposits, and began to unfreeze them in mid-1995.

[FIGURE 1 OMITTED]

The other line looks only at 'new' deposits (those made after mid-1991). What is somewhat remarkable is that the share of fx deposits in new deposits actually increases noticeably after stabilisation, rising from a low of 56.3 % in August 1994 to a high of 78.1% in February 1999.

In addition to deposit dollarisation, it would be logical to look at a measure of overall dollarisation that included foreign currency in circulation (FCC) as proposed by Feige et al. (2002a). The Euro conversion process provided an unprecedented opportunity for measuring FCC, since savers had to convert their 'Euro-in' notes to Euro notes in some way. In Croatia, following a concerted public relations campaign by the Croatian National Bank and the commercial banks, savers mainly deposited their 'Euro-in' currencies in bank accounts before the end of 2001. Banks then allowed them to withdraw Euros freely without any fees after the New Year. (3)

Croatian banks experienced enormous deposit inflows at the end of 2001. Based on measurements of the inflows, and Austrian National Bank surveys on the currency composition of FCC, (4) the CNB has estimated that the total stock of FCC was 3.58 billion [euro] at the end of 2001. This implies that the ratio of FCC to FCC plus local currency in circulation was 75.6%, and that the overall ratio of FCC and foreign exchange deposits to total currency in circulation and deposits (kuna and foreign exchange) was 74.4%. Intuitively, it is plausible that the ratio of foreign currency to total currency in circulation is roughly equal to the ratio of foreign currency deposits in total deposits.

A further interesting finding from the Euro-conversion process is that about 1 billion Euro flowed out of the banking system in the first 3 months of the new year. A run at Rijeka Banka in mid-March, prompted by losses incurred by a foreign exchange dealer, probably accounted for about 200 million Euro this total. However, it seems likely that the majority of the total outflow, which occurred without major public attention, represents a rebuilding of desired stocks of foreign currency in circulation. If so, this testifies to the persistence of preferences for holding foreign currency cash.

It is obvious from the deposit data that Croatians continue to prefer foreign exchange as a store of value. Anecdotal evidence suggests that foreign exchange is in use as transaction money as well, but mainly in an unofficial way. One cannot make payments in a store or through a bank account in foreign exchange. However, cash transactions, particularly private transactions such as those used for car and apartment sales, are sometimes made in foreign exchange.

Why has dollarisation remained so high in the face of successful stabilisation? Usually, high dollarisation is attributed to lack of credible monetary policy. Credible monetary policy implies confidence that inflation will remain low, that the exchange rate will remain reasonably stable (since Croatians' consumption basket includes a significant proportion of imports, people implicitly measure their living standards to a great extent by their command over foreign goods) and that convertibility will not be revoked. These conditions have been met for 8 years now, but it seems that the Croatian public does not yet have confidence that these conditions will be met in the future.

This apparent difficulty in restoring confidence seems hard to explain. The implicit model in the 'lack of credible monetary policy' story is one in which expected returns on holding domestic currency continue to be lower than expected returns on holding foreign currency because actors assign nonzero probabilities to substantial inflation, devaluation and/or confiscation.

If this is the explanation of continued dollarisation, what we would need to explain is why Croatians continue to expect high inflation and exchange rate depreciation after such a long period of stability. Most likely, the best explanation would be previous negative experience. That is, Croatians continue to place a positive, although perhaps small probability, on a large-scale depreciation or increase in inflation. Even if the probability of this 'nightmare scenario' is low, if it is sufficiently bad, it could keep the expected loss on holding domestic currency above that for holding foreign currency. If expectations of a 'nightmare scenario' cannot be unwound, there could be a ratchet effect in which dollarisation only increases.

Alternatively, one might explain dollarisation persistence via the presence of network externalities. In this view, the fact that others use foreign exchange decreases transaction costs for any individual. When a certain threshold is passed, the majority of actors switch to foreign exchange. (5) This 'switching' phenomenon results in multiple equilibria (a low dollarisation equilibrium and a high dollarisation equilibrium).

The models have somewhat different implications. In the credibility model, there is still some chance that dollarisation could be reversed over a long period of time by good monetary policies. However in the network externalities model, good monetary policy cannot reverse dollarisation; only a massive appreciation of the domestic currency could cause the drastic shift to the low dollarisation equilibrium. In fact, the network externalities model provides an attractive explanation of the coexistence of good monetary policy and persistent dollarisation.

Unfortunately, at this point, we do not have clear empirical evidence to distinguish between models of dollarisation persistence. However, experience so far suggests that dollarisation will not be quickly reversed. It therefore seems wise to accept that dollarisation is here to stay as a fact of life for monetary policy makers in Croatia.

Exchange rate flexibility under dollarisation

While it is generally accepted that high levels of dollarisation place heavy constraints on monetary policy, the Croatian case provides an excellent opportunity to explore these constraints empirically. In this section, I look at three main ways in which dollarisation limits exchange rate flexibility: balance sheet effects, currency substitution and pass-through.

Regarding balance sheet effects, the structural issue is that banks have foreign exchange deposits as the major item on the liability side of their balance sheets. To be precise, foreign exchange liabilities accounted for 67.6% of banking system liabilities at the end of 2001. Only 35% of total assets are in foreign currency. Until 2001, banks were only allowed to make loans in foreign exchange to domestic companies for specific import purposes. This regulation was liberalised in June 2001. However, since domestic payments can only be made in kuna, the level of foreign exchange loans has not grown dramatically.

The only reasonable way for banks to match their currency exposures is to index domestic currency loans to the exchange rate. Such indexed loans account for 31.9% of total assets. Thanks to indexation, banks' open positions are relatively small, and banks can switch relatively quickly from short to long positions. (6) Even a fairly substantial depreciation would not have a massive direct effect on balance sheets. Crude calculations based on end 2001 data suggest that a one-off instantaneous depreciation of 10% would cause losses of only 0.5% of total assets, and would lower system-wide capital adequacy from 18.5% to 17.5%. Banking sector profits were about 0.9% of total assets in 2001, so that such a shock would roughly cut profits in half, but would not wipe them out entirely.

While this formally covers the exchange rate risk on the balance sheet problem, it creates credit risk to the extent that borrowers do not themselves have fx income sources. There is reason to believe that many borrowers taking loans with foreign exchange clauses do not have much foreign exchange income. First, exports are highly concentrated among firms, with seven firms accounting for roughly 25% of Croatia's exports: the oil company INA, the pharmaceutical company Pliva and the five shipyards. Second, banks have indicated that they do not take the currency composition of firm's income streams into account when granting loans with the indexation clause, but instead routinely include this clause on many types of loans.

A sharp one-off depreciation of the currency would trigger the indexation clauses, raising loan installments, and certainly raise the level of defaults. In other words, in case of a significant depreciation, the banks would have rather small losses due to revaluation effects on their balance sheets, but potentially very large losses due to deterioration of lending portfolio quality. Although the level of potential losses is not easy to quantify, it seems probable that even a one-off depreciation of 10% would trigger substantial losses.

The second immediate issue emerging from the high level of dollarisation is currency substitution. If a depreciation shock created expectations of further depreciation, agents would tend to adjust their portfolios in favour of foreign exchange. A large shock or some other event that substantially raised agents' expectations of depreciation going forward could trigger a major portfolio adjustment.

During the years since stabilisation, there have not been any explosive movements in the currency composition of savings. As Figure 1 above showed, there was an almost uninterrupted increase in the fx component from 1995 through early 1999 (excluding the frozen deposits), and since then the fx share has fluctuated between approximately 0.7 and 0.75. However, this relative stability in recent years does not guarantee stability under all circumstances in the future. In particular, if a government were to embark on a policy of export promotion via devaluation, it is not hard to imagine a panic in which agents decide that the 'bad old days' of devaluation-inflation cycles have returned. This would lead to a flight from the kuna, which, of course, would exacerbate the vicious cycle.

One can debate whether this series of events is realistic. However, given the difficulties of predicting mass psychology, one would have to seriously weigh the probability of such an event before embarking on such an expansionary policy. This is another argument against the use of the exchange rate as an active policy instrument in Croatia.

The third point that should be considered when discussing the implications of dollarisation is pass-through. In general, it is supposed that high levels of dollarisation should imply high levels of pass-through. In Croatia, casual empiricism suggests that many prices are informally linked to the kuna-euro exchange rate. People tend to think of prices in euro terms, and adjust the kuna countervalue accordingly. Particularly in the tourist industry, prices are indeed often quoted directly in foreign exchange for foreign guests.

Such observations would seem to suggest that pass-through of exchange rate changes onto prices should be fairly high. Gattin-Turkalj and Pufnik (2002) estimates pass-through using the modelling strategy initiated by McCarthy (2000). The model uses pricing along the distribution chain to explain inflation at the particular stage, imported inflation, producer price inflation and consumer price inflation. Inflation at the particular stage at time t is explained by several factors. First comes expected inflation using all available information at the time t-1. Second come shocks: supply shocks, proxied by oil prices shocks, demand shocks proxied by output gap shocks and exchange rate shocks. Third come the effects of the inflation shocks at the previous inflation stages, and fourth and last the inflation shock at that particular stage of the distribution chain. The shocks at each stage are that portion of a stage's inflation that cannot be explained using information from period t-1 plus contemporaneous information about shocks and inflation at the previous stage of the distribution cycle. These shocks can be thought of as changes in the pricing power markups of firms at these stages.

The Gattin-Turkalj model was estimated with monthly data from January 1998 to April 2002. Figure 2 shows some of the impulse responses of the producers' price index (PPI). There is a clear pass-through with the exchange rate and with oil prices. Effects of the output gap and MI are more muted. The impulse responses of the retail price index are minimal, and are not shown here.

[FIGURE 2 OMITTED]

The estimated coefficients indicate rather modest levels of pass-through. An instantaneous one-standard deviation (3.6 percentage point) exchange rate shock would increase PPI inflation by about 1 percentage point. However, RPI inflation hardly reacts at all, and core inflation also has virtually no reaction when it is placed in the model instead of RPI or PPI. (7)

There are several possible explanations for the relatively low level of pass-through found in both studies. First, it is possible that exchange rate changes may have been perceived to be temporary, decreasing the degree of pass-through. Second, related to this, there may be some thresholds, due to menu costs, below which actors do not find it worthwhile to alter prices. Third, the central bank has consciously smoothed exchange rate fluctuations so as to manage inflationary expectations, so that this model may not tell us much about hypothetical situations in which larger exchange rate fluctuations might have destabilising effects. Fourth, it may be that pass-through is asymmetrical, due to sticky prices: actors increase prices in kuna when the kuna depreciates, but do not lower them when the kuna appreciates. Fifth, following Taylor (2000), it may be that low inflation causes lower perceived persistence of cost changes, and thus lower pass-through.

The discussion in this section suggests two things. First, there are strong limits on the feasible use of the exchange rate as an active policy instrument. A policy based on substantial exchange rate depreciation would run the risk of large-scale credit losses and of currency substitution leading to a vicious cycle of devaluation and inflation. Second, results from a VAR model with exchange rate volatility (not shown here) indicate that there are some benefits from limited exchange rate flexibility. Exchange rate volatility seems to help decrease pass-through, and the policy of limited exchange rate flexibility has been adequate to achieve low inflation.

The next question to address is whether the exchange rate regime can be improved, or is the current regime the best available solution?

MONETARY POLICY OPTIONS

Adopting the Euro

Given that high dollarisation limits exchange rate flexibility, some have suggested that Croatia should introduce the Euro as its currency, or, along similar lines, adopt a currency board arrangement with the Euro. Of course, the European Commission has thus far taken a position against any unilateral adoption of the Euro by current candidates or possible future candidates. This discussion, therefore, is somewhat theoretical; we will discuss whether adoption of the Euro would be economically justified if the Commission at some point agreed to allow candidates to adopt the Euro before they became members of the EU and/or before they successfully meet the conditions of ERM 2 for 2 years. In other words, the following discussion is purely economic and hypothetical.

Some countries have adopted dollarisation and currency boards as solutions to dire economic problems. Countries facing chronic instability such as Ecuador, Argentina, Bosnia and Bulgaria have used 'hard fix' policies to anchor expectations and prevent irresponsible policies. The phrase 'tying one's hand' and the question 'Is monetary policy so bad that it would be better not to have it at all?' come from the experience of such countries. (8)

The main point of such arguments is usually that the central bank is unable to contain inflation. Indeed, many models of dollarisation assume that the main benefit would be reducing inflation to the level of the vehicle currency country (the US for Latin America, Euroland for transition countries). However, Croatia's recent record of low inflation makes such arguments somewhat irrelevant.

The obvious drawback of dollarisation is the loss of seignorage (Fischer, 1982). As Chang and Velasco (2002) argue, in theory, the existence of seignorage, along with the possibility of employing time-inconsistent monetary policy, make having a national money clearly Pareto-superior in a world without uncertainty. However, in a world with uncertainty and in particular with difficulties in making credible commitments, the case is theoretically indeterminate.

Furthermore, rough calculations suggest that seignorage revenues are relatively small, less than 1% of GDP, and could easily be outweighed by various types of gains. Berg and Borensztein (2000) suggest two alternative measures of seignorage: the reserve-money method and the central bank profit method. The reserve-money method defines S = [DELTA]R/P, where R is the reserve money and P is the price level. The central bank profit method defines S = [i.sup.A] A-[i.sup.R] R, where [i.sup.A] is the interest rate that the central bank gains on its assets, A is the quantity of central bank assets, [i.sup.R] is the interest rate that the central bank pays on reserve money, and R is the quantity of reserve money. Using these definitions, seignorage in Croatia is shown in Table 1.

These numbers are not totally negligible (especially the extraordinarily high reserve money method seignorage in 2001, which is a side-product of the Euro conversion). However, even if the Minister of Finance would like to keep this seignorage in the Treasury's hands, it is easy to imagine that other effects could well be larger, especially if they relate to macroeconomic stability.

Let us now look at some other arguments:

(1) Interest rates would fall. This is conventional wisdom regarding dollarisation (see for example, Dornbusch, 2001). However, at a theoretical level, Chang and Velasco (2000) develop a model of dollarisation, that considers the effect of eliminating the lender of last resort facility on the possibility of what they call 'international illiquidity' or a run of international creditors. They find that there are conditions under which such runs would not be possible with a flexible exchange rate, but would become possible under dollarisation. Under such conditions, dollarisation would increase interest rates by increasing default risk. For countries with a history of banking sector instability, such as Croatia, this could become relevant, particularly if new stresses emerged in the banking sector.

Additionally, the presumption behind arguments that interest rates would fall after dollarisation is that a good part of the interest rate spread is actually due to currency risk. However, it is interesting to note that spreads between first-tier accession country bonds and German bonds have become extremely small without euroisation. In fact, at some points, interest rates on Czech government bonds have fallen below those on corresponding German bonds. This narrowing of spreads is partly driven by 'convergence plays' by portfolio investors, and can be expected to manifest itself for other accession countries as they reach the final stages of negotiations with the EU. (9)

Furthermore, the current values of Croatian spreads are only about 120 basis points. The spread has fallen substantially since the new government was elected in 2000 and in particular since a precautionary stand-by arrangement was reached with the IMF. The announcement effect of the agreement in late 2000 was substantial, as can be seen from figure 3. During the subsequent period, spreads fell roughly 100 basis points. If Croatia continues its cooperation with the IMF and advances further in the EU accession process, as expected, the convergence of spreads might continue even further, and the space for further effect of euroisation on interest rates might be extremely small.

[FIGURE 3 OMITTED]

(2) A hard peg would discipline fiscal and wage policy. Eichengreen (2002) discusses this issue very carefully, and draws rather pessimistic conclusions. It does not seem that a hard peg is an adequate straitjacket to prevent distributional conflicts. Politicians can blame each other for failure to restrain spending, and unions do not seem to be much impressed by the macro consequences of their actions in many cases. Of course, the argument is that eventually, the negative impact of expansionary fiscal and wage policy will create such unbearable economic burdens that governments and unions will eventually cave in. It seems adequate to refer to the Argentine experience to refute this line of thinking.

In Croatia, fiscal consolidation has made progress since 2000 (see Kraft and Stucka (2002) for details). However, as in most countries, distributional struggles continue, with strong political pressures to increase both public investment (eg, road construction) and transfers (especially pensions). It is hard to believe that euroisation would substantially soften this distributional struggle.

(3) Euroisation would remove the currency mismatch from bank balance sheets, allowing safer and sounder banking. This argument seems rather strong, for as we have shown, the current practice of indexation does not really solve the mismatch problem. It seems certain that euroisation would remove important risks from the banking system, even if it had little or no effect on interest rates.

At the same time, quite a few observers of the Asian crisis have blamed fixed exchange rates for creating complacency about the currency mismatches involved in foreign borrowing (see, for example, Summers, 2000; Fischer, 2001). However, Arteta (2001) shows that cross-country data imply that greater dollarisation and especially greater balance sheet mismatches are associated with greater exchange rate volatility. This result seems logical, because with greater volatility, depositors demand a higher fraction of foreign exchange deposits. Even if greater volatility increases lending in domestic currency, due to greater perceived risks of foreign borrowing by credit recipients, the increase in deposit dollarisation actually increases bank balance sheet mismatches. The empirical evidence on the behaviour of deposits in Croatia (see above) also supports this thesis. In other words, the problem of balance sheet mismatches strengthens the case for euroisation, and not the case for greater exchange rate flexibility.

(4) Euroisation would make a lender of last resort function difficult or impossible. In fact, if euroisation were carried out through a purchase of kuna currency in circulation with a portion of the CNB's reserves, the CNB would still have reserves left over. This could be supplemented with standing lines of credit, as in the Argentine case. Thus, some sort of a lender of last resort facility under euroisation might be possible.

Several uncertainties remain, however. One is the actual size of lender of last resort credit needed. In the 1998-1999 crisis, CNB lending to banks amounted to a maximum of about 1.2 billion HRK, or a bit over 150 million USD. Such an amount would not strain the reserves of the CNB, even after purchasing all the kuna in circulation. However, a larger crisis might be a different story and the use of standing facilities has never really been tested, so that it is difficult to be sure whether commercial banks would in fact honour their comments to a country that was faced by systemic banking crisis. Under these circumstances, it seems inadequate to rely mainly on external credit lines. (10)

(5) Adoption of a common currency would substantially raise trade with Euroland. Here we have the arguments developed by Rose (2000) and Rose and Van Wincoop (2001). Very briefly, they find that when a variable representing the adoption of a common currency is included in gravity models of trade, the variable has statistically and economically significant coefficients. Their conclusion is that countries that have a common currency trade more with each other, ceteris paribus, than countries that do not have a common currency. For EU accession countries, the authors estimate that the simple adoption of the Euro would raise trade by 25-50%.

This work is controversial, and I will not attempt to resolve the controversies here. Certainly, if Rose and van Wincoop's estimates are correct, there would be a big payoff to euroisation (and apparently a greater payoff to euroisation than to adoption of a currency board). However, there is a great deal of controversy about what gravity models actually show, and even more controversy about the real economic meaning of adding a dummy variable for common currencies into a gravity model. Thus, at the moment, it is difficult to either accept or reject Rose's arguments with any great deal of confidence.

(6) Euroisation would eliminate exchange rate risk. One cost of exchange rate flexibility is the cost of hedging. Euroising would eliminate this cost. However, so far very few Croatian companies hedge, so that the practical significance of this argument seems small. Nor is there very firm empirical evidence on the effects of exchange rate risk on trade, for example (see point 5).

(7) Euroisation would make control of inflation more difficult. A very important question is the effect of Euroisation on inflation. In cases of large-scale macroeconomic instability, dollarisation has been used to decrease inflation. However in the Croatian case, inflation is already low, so this benefit of dollarisation would not be significant.

Furthermore, there are several reasons to believe that a real appreciation of the exchange rate is to be expected in the coming period. One reason is the Balassa-Samuelson effect; another is the expected high level of capital inflows as Croatia's credit rating improves and as investors anticipate eventual EU accession. If the extent of the real appreciation is exogenous to the choice of exchange rate regime--a big if--then fixing the exchange rate (either via dollarisation or via a currency board) will result in higher inflation.

What is the difference between real appreciation occurring purely through inflation or real appreciation occurring through a combination of inflation and nominal appreciation? One pragmatic answer is that the latter is more likely to be compatible with the Maastricht criteria. Another, perhaps slightly less pragmatic answer, is that a combined approach might make inflation easier to control, given that the exchange rate could still be used as an instrument. However, on the other hand, if the exchange rate can move, it may overshoot, causing substantial problems.

However, one could ask to what extent inflation should remain a focus once a country adopts the common currency. After all, price convergence within the Eurozone is expected and even welcome. Rogers (2001) finds evidence that inflation rates in the Eurozone are already closely correlated with price-level differentials, so that countries with low price-levels face higher inflation. It is not obvious whether this kind of higher inflation is something that should be frowned upon. (11)

Of course, Croatia or other accession countries adopting the Euro before membership, would not be members of the Eurozone in the full political sense. They presumably would not he allowed to have representation on the bodies of the ECB. Moreover, it is understandable that the European Commission is hesitant to encourage countries to adopt the Euro without the full set of political rights that have so far been associated with it.

(8) Financial crisis and ERM 2. With exchange rate flexibility comes at least the possibility of currency crisis. Begg et al. (2003) argue that accession countries entering the ERM 2 may be highly exposed to speculative capital flows and thus run serious risks of currency crisis. Their recommendation is that the European Commission actually allows early adoption of the Euro, mainly to prevent currency crises.

This is a version of the 'corner solutions' thesis, which of course has been subject to substantial debate. However, we do have some past experience, in particular, the ERM crisis of 1992-1993, to look back at. Can we exclude the possibility of a shock occurring in Euroland, like German reunification, that changes the fundamentals and puts exchange rates for ERM 2 members under stress? Might it be better to find a mutually agreeable way to 'crisis-proof' ERM 2?

Since the arguments about Euroisation are rather complex, it may be helpful to the reader to see a summary. Table 2 provides such a scorecard.

At this point, the only clear strong arguments for Croatia adopting the Euro are banking system currency mismatches and the possibility of currency crisis during the ERM 2 process or more broadly during the later stages of accession. This suggests that the argument for euroisation might increase as Croatia gets closer to accession, which at the moment is far from imminent. (12) However, since there are other negative arguments, most particularly the lender of last resort issue, it seems fair to say that the case for immediate euroisation is mixed at this point.

Inflation targeting

Inflation targeting has many attractions in general, and in particular, for Croatia. In general, inflation targeting is often praised for transparency, for allowing the possibility of democratic control (Mishkin, 1999), and for stabilising expectations. In particular for Croatia, inflation targeting has the following positive features:

* it is the monetary policy framework of the ECB (13)

* it is the framework adopted by most of the first wave of EU accession transition countries (Czech Republic, Hungary, Poland)

* Croatia already has achieved low inflation, so that a long period of disinflation would not be required at the start

* it might work to decrease agents' focus on exchange rate changes, and ultimately delink exchange rate and inflationary expectations (14) * the new Law on the Croatian National Bank, passed in 2001, makes price stability the main goal of the CNB.

However, there are a few difficulties in the way of the implementation of inflation targeting in Croatia.

(1) What to target: First is the question of which measure of inflation should be targeted. This is a problem that is faced by all inflation targeters. The dilemma is the following: energy and food prices are usually substantially more volatile than the rest of the CPI. A core price index, which removes their influence, is often considered to give the best representation of the medium-term trend of inflation. (15) Furthermore, when tax systems are rapidly changing, a net price index, which eliminates the influence of direct taxes from the core index, can be argued to be the optimal target. (16)

However, a key goal of inflation targeting is transparency. The public may consider use of core or net inflation as nontransparent, in part because they do not understand the indices, and in part because they suspect that the adjustments to the price index leave something important out. (17)

This is a dilemma that does not have a theoretical answer. However in practice, most countries have opted to target headline inflation, while closely monitoring core inflation and sometimes net inflation as well. The ECB does this, as do the transition country inflation targeters (Poland, Czech Republic, Hungary). (18)

(2) Band versus point target. Let us suppose that Croatia chooses to target headline inflation as a way to ensure transparency of the inflation targeting regime. The next question is whether to target a band or a point. The trade-off here is that, while a band is easier to hit, a point target gives more focus to expectations. Obviously, the wider the band, the less credible (and transparent) the policy. (19)

Poland, the Czech Republic and Hungary all have target bands. This seems to be reasonable, given the limited time series available for modelling, the limited monetary policy instruments available due to relatively less-developed financial markets, and the continued occurrence of large shocks related to the structural changes required by convergence and EU accession.

(3) Can the target be met? Here, Croatia will have the luxury of looking at the experience of the more advanced transition countries. The question is not only whether the target can be met, but also whether 'small' deviations from the target band will have major impacts on credibility.

For Croatia, the problem with meeting the target might be quite serious. The pass-through analysis above indicated that producer prices are strongly impacted by world market prices for oil and energy. Producer price changes pass-through to retail prices with a lag. So far, the Croatian National Bank has not been able to offset this imported inflation completely through other policy instruments.

Furthermore, as I have already argued above, the room for exchange rate flexibility is limited. Frankel (1999) points out that Israel increased the width of its bands during its inflation target period. The widening of the bands was also related to a more liberal foreign exchange regime; as Frankel picturesquely put it, if people are driving faster cars, they need a wider road. In Croatia, however, thanks to dollarisation, the cars are very hard to steer and perhaps should not be driven fast at all (ie perhaps a widening of the range of acceptable exchange rate flexibility is not wise).

The technical problems of short time series and difficulties in creating adequate forecasting models are particularly acute in Croatia. Owing to the war and high inflation, data from before mid-1994 are simply not useful. Also, the fact that very important infrastructure prices were controlled until recently makes it difficult to rely on historical data completely.

These technical problems probably do not constitute insurmountable obstacles to inflation targeting in Croatia. Other countries, particularly emerging market countries, have faced similar dilemmas. Instead, the biggest problem facing Croatian inflation targeting would probably be the question of the exchange rate. At least at first, exchange rate management would probably remain unchanged and, in that case, one might wonder whether anything had really been accomplished, other than giving the current policy a new name.

If it ain't broke, don't fix it

There is, of course, another possibility: simply to continue with the present monetary policy framework. For the moment, the policy of the Croatian National Bank is to maintain the status quo. However, 4 years after the ratification of the Stabilisation and Association Agreement, Croatia will have to eliminate all capital account restrictions. Realistically speaking, this will not come about until at least 2007.

In other words, at least for the moment, a policy of 'If it ain't broke, don't fix it' seems to be the prudent course.

Table 1: Seignorage estimates

 1999 2000 2001

Reserve money method
Change in reserve money 355.8 1407.3 6085.9
As % of GDP 0.25 0.89 3.60

Central Bank profit method
Interest on int. reserves 784.1 1306.7 1524.8
Interest paid on required reserves 380.2 533.9 464.6
Seignorage 403.9 772.8 1060.2
As % of GDP 0.25 0.49 0.63

Table 2: Summary of arguments on euroisation

Seignorage -
Interest rates +/0
Discipline fiscal policy 0
Banking system currency mismatches +
Lender of last resort -
Trade promotion with EU +/0 (?)
Exchange rate risk and hedging costs +/0
Inflation management -
Possibility of currency crisis +

+, argument for euroisation; 0, argument not
relevant/convincing; -, argument against euroisation.

(1) I thank without implicating Katja Gattin-Turkalj, Vedran Sosic, Maroje Lang, Paul Wachtel, Kresimir Zigc and an anonymous referee for comments and input. All remaining errors are the author's. This paper does not necessarily reflect the views of the Croatian National Bank.

(2) To be precise, the arrears were cleared by a combination of cash payment, netting of claims and issuance of bonds.

(3) In fact, the banks generally extended the deadline for free conversion via depositing to 31 March 2002, the official end of the conversion period for most of the 'Euro-in' currencies.

(4) About 80% of FCC was in 'Euro-in' currencies, so that an estimate of total FCC is correspondingly larger than the estimated amounts of 'Euro-in' currencies converted to Euros.

(5) See Feige et al. (2002b) for an elaboration of a formal network externalities model and an application to Argentina. Also, Oomes (2001) finds that the network externalities model fits the data for Russia better than a ratchet/hysterises model.

(6) The Croatian National Bank requires that banks' open positions be less than 20% of regulatory capital.

(7) Billmeier and Bonato (2002) employ a similar model, and then add a VECM to obtain long term results. They find a long-term cointegration relationship, and estimate that a devaluation of 10% would imply a rise of RPI inflation of 0.6 percentage points in the long run. The authors do point out that their estimated coefficients are higher than in other similar economies such as Slovakia. Nonetheless, they do not seem to correspond to the highly indexed economy that is generally expected.

(8) Tying one's hands' comes from Giavazzi and Pagano (1988), and 'Has Monetary Policy Been So Bad That It Is Better To Get Rid of It' is from del Negro and Obiols-Homs (2001).

(9) In a rather different context, de Zamaroczy and Sa (2002) note that Cambodia continues to suffer from very high interest rate spreads despite near complete (unofficial) dollarisation. This highlights the need to consider country risk as well as currency risk.

(10) I would like to thank Curzio Giannini for helpful discussion of this issue.

(11) in fact, at a recent conference, Jurgen van Hagen pointed out that once a common currency is adopted, the term inflation should be reserved for inflation in the whole zone of operation of the currency, not the individual countries. Inflation, he reminds us, is the change in the value of money relative to goods.

(12) Croatia submitted its application for EU membership in the first half of 2003.

(13) To be precise, the ECB's policy has two pillars, an inflation target and monetary aggregate targets.

(14) An interesting discussion based on this issue was the Israeli experience found in Frankel (1999).

(15) For example, the Bank of Canada (1991) justifies focusing on core inflation with the argument that it is less volatile than the CPI as a whole, and therefore provides more insight into inflationary trends.

(16) Net inflation indexes are used in Canada, the UK and the Czech Republic.

(17) IMF (2000) notes that most non-industrial countries target headline inflation for transparency reasons.

(18) The Czech Republic began targeting core inflation, but switched to headline inflation in April 2001.

(19) This issue and other practical issues of inflation target implementation are discussed in Blejer et al. (2000).

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EVAN KRAFT (1)

Research Department, Croatian National Bank, Trg Burze 3, 10002 Zagreb, Croatia. E-mail: [email protected]