According to the IMF, Croatia’s economy is set to be harder-hit by the coronavirus pandemic than any other country in south-east Europe. While most Balkan nations are predicted to see their GDP drop by 3-5% in 2020, Zagreb is looking down the barrel of a painful 9% contraction. This bitter blow is in part due to Zagreb’s outsized reliance on tourism: anything like a normal summer season is unlikely this year for Croatia’s tourism sector, which contributes some 20% of the country’s GDP.
The financial crisis comes at a particularly bad time for the EU’s newest member state. After years of waiting, Croatia was planning to join the exchange rate mechanism (ERM-II) this summer. Spending a minimum of two years under the ERM-II scheme with a stable currency and a healthy banking sector is an essential prerequisite to Zagreb’s hopes to adopt the euro by 2024 at the latest.
While the Croatian central bank is insisting that it’s still ready to enter the euro waiting room this summer despite the economic downturn prompted by the pandemic, it’s difficult to see how Croatia could fulfill the criteria for adopting the single currency while recovering from the world’s worst financial crisis since the Great Depression. A particular challenge will be to bring public debt under 60% of GDP. Zagreb had made progress on this front before the coronavirus outbreak, but debt is likely to soar as the government tries to staunch the bleeding on the jobs market.
What’s more, the virus-related financial damage is likely to draw renewed attention to a number of missteps, from Zagreb’s backsliding on questions of corruption to its much-maligned currency conversion of loans, which have left Croatia’s economy on shaky ground.
The Croatian government has stepped up its courting of foreign investment in recent months as it attempts to get its finances in order ahead of euro adoption, but pervasive graft and financial crime continue to cause overseas firms to flee. Croatia loses over 10% of its GDP annually to corruption and fraud—a lacuna which will make it that much harder for Zagreb to cope with the pandemic-induced downturn.
To make matters worse, the ease of doing business in the country has actually slumped since Croatia joined the EU in 2013. This January, Zagreb sunk to its worst level in five years on Transparency International’s corruption index, amid concerns that a lack of scrutiny from the European Union since Croatia’s accession to the bloc has eaten away at progress to stamp out graft.
Questions over the independence of the judiciary and Zagreb’s willingness to take a hard line on graft abound, with little sign of progress. As the head of one NGO promoting the rule of law put it, “there is no external pressure to encourage change, the [European] Commission, for example, has abolished the anti-corruption reports it once had.”
It’s not only Croatia’s backsliding on corruption, however, which has spooked foreign investors. Their confidence in Croatia’s investment environment has been badly shaken by a particularly controversial decision: Zagreb’s conversion of loans denominated in Swiss francs (CHF) to loans denominated in euros, for which it left banks to pick up the tab.
In the 2000s, CHF loans were popular in Croatia and other Eastern European countries thanks to their low interest rates and the Swiss currency’s stability. In January 2015, however, the Swiss central bank dropped the peg which had locked the Swiss franc into a fixed exchange rate with the euro for years — sending the Swiss franc soaring and making it more difficult for Croatian borrowers to pay back their CHF-denominated loans.
Croatia’s reaction to the sudden surge in the Swiss franc alarmed foreign investors and European policymakers alike. Right before they were voted out of office in November 2015, Croatia’s Social Democrats pushed through a law forcibly converting all loans in CHF to loans in euros. More specifically, the conversions were carried out retroactively, using the CHF/EUR exchange rate in force on the day that the loan had initially been concluded. In many cases, this method of conversion meant that customers had significantly “overpaid” in their monthly installments—a €1.1 billion loss which Croatia forced its banks to swallow.
The measure’s problematic consequences were almost immediately apparent. Members of the new Croatian government declared that the outgoing Social Democrats had “not thoroughly thought through the conversion and had implemented it in a populist manner”. The European Commission asked Zagreb to rethink the law, arguing that it dealt a severe blow to investor confidence and placed a disproportionate burden on the country’s local banks—more than 90% of which are owned by parent companies from elsewhere in the European Union.
The European Central Bank, meanwhile, opined that while an EU directive allowed countries to regulate foreign currency loans, they were excluded from doing so with retroactive effect—raising the question of whether Croatia’s loan conversion legislation was compatible with European law.
Nearly five years after the law on loan conversions was passed, it’s still prompting legal battles and undercutting investor confidence. I parallel with Zagreb’s legislative crackdown on CHF loans, a lawsuit initially launched by a Croatian consumer association has slowly made its way through the country’s courts. As things currently stand, Croatian courts have declared the currency clauses which denominated the loans in CHF in the first place null and void, meaning that individual consumers can seek compensation from banks—including for loans which have already been repaid.
Even before Croatia’s finances took a nosedive amid the current pandemic, banks and financial analysts were warning that the CHF loans saga had fragilized the country’s banking sector. If the Croatian Supreme Court rules that banks must compensate borrowers above and beyond the initial capital of their loans, they could bear fresh costs of close to €2.5 billion. Such a blow could, along with the steadily growing pandemic damage, serve as a one-two punch to Zagreb’s hopes to join the ERM-II this summer.