1. Household Lending in Croatia: a Comparative Perspective Evan Kraft Advisor to the Governor Croatian National Bank The views expressed in this paper are the authors own and not necessarily those of the Croatian National Bank.

2. Motivation Literature, both theoretical and empirical, points to links between lending booms and banking and currency crises A previous paper at this conference (Kraft and Jankov 2005) noted that Croatias post-2001 lending boom may be less dangerous than 1995-98 due to greater share of household loans Croatias current lending boom has been associated with current account problems. But Herrman and Jochem (2005) argue that high current account deficits are normally associated with the catching-up process and should reduce as GDP/capita rises. Of course, this does not mean that there are no dangers here! Both the growth rate of household loans and share in GDP in Croatia are exceptionally high relative to other transition countries

3. Main questions Are repayment rates on household loans still holding up? And if so, how can this be reconciled with the rapid rate of growth of household credit? Are there any special macroeconomic implications of this heavy share of household lending? In particular, how does consumption lending get reflected in balance of payments issues? Is Croatia's seemingly high share of household loans actually high in broader cross-country comparison, and what determinants can be found for this high share?

4. Loan growth since 2000

5. Household lending to GDP in transition countries, 2005

6. Current account and fiscal balance, %GDP

7. Foreign debt, % GDP

8. Policy measures to limit lending growth and foreign debt 2003: tax on lending growthif loans grow more than 4% per quarter, banks must purchase low-yield central bank securities (twice as much as the overrun) 2003: prudential measuresbanks with rapid credit growth must retain a portion of dividends (effectively higher capital adequacy) 2004: marginal reserve requirementextra reserve requirement on increases in banks foreign liabilities. Rate initially 24%, now 55% 2005-6: retirement of some government foreign debt and replacement with domestic debt 2006: guidelines on banks management of foreign currency induced credit risk (FCICR)

9. Past-due loans to households, %

10. Detailed break-down of past-dues

11. Distribution of household loans by disposable income

12. Prudential indicators still do not show any obvious danger signs Of course, both loan-loss provisioning and past-dues are backward-looking Certainly, in a recession, we would expect increased past-dues and defaults.

13. Econometric strategy for cross- country regressions Use large sample of 90 countries to establish broad determinants of household lending to GDP Then look at residuals for transition countries Analyze these residuals with variables available for transition countries only to see if Croatia is exceptional

14. Determinants of household lending GDP per capita Macroeconomic stability, particular low inflation Enterprise use of direct finance and equities Institutional development and quality Legal origin Regional effects Transition country effects

15. Basic messages of the first-stage regressions Strong explanatory power of GDP/capita Inflation record also significant Legal origin variables perform well Corruption significant Direct finance (market capitalization of listed companies) nearly significant

16. Variables used for the second- stage regressions Banking sector reform (EBRD index) Privatization indices Enterprise reform scores Non-bank financial institution reform

17. Second-stage results Strong, significant estimates for banking reform, privatization and enterprise reform Most interestingly, Croatias residuals are no longer outliers.

18. Conclusion: explaining high consumer lending in Croatia Victim of success: low inflation, strong banking reform lead to high household lending Slow reforms: stagnant privatization in recent years, slow enterprise reform, high and unchanging corruption, continued weaknesses in institutional environment Conclusion: EU accession provides an ideal opportunity to speed up reform, which, among other things, will make it easier for banks to lend to enterprises and decrease some of the focus on lending to households