Content area
Full Text
Even after more than a decade of low inflation, Croatia remains highly dollarized. Commercial banks avoid currency mismatch by indexing loans to the exchange rate. Although this eliminates direct currency risk, it creates credit risk, because any larger depreciation might induce borrower defaults. Monetary and exchange rate policies focus on exchange rate smoothing to safeguard financial stability. Dollarization has prevented the use of monetary policy to stabilize output. Given Croatia's likely entry into the EU and adoption of the Euro, dedollarization seems unfeasible. Rather than attempting to reverse dollarization, the central bank has taken measures to make the banking system more robust to shocks.
(JEL E52, E58, F31, G21, P24)
ABBREVIATIONS
GDP: Gross domestic Product
IMF: International Monetary Fund
I. INTRODUCTION
At first glance, Croatia seems to share the problems of other Central and Eastern European countries. It is a small economy, troubled by large and volatile capital flows (Sonje and Vujcic 1999) and periods of rapid credit growth threatening financial stability (Mihaljek 2003; Kraft and Jankov 2005). The process of structural change fostering real convergence toward the EU, coupled with success in implementing structural reforms, prompted several of the advanced transition countries (Hungary, Czech Republic, Poland, and Slovakia) to gradually introduce more flexible exchange rate regimes (Corker et al. 2000). However, Croatia differs from these countries for reasons other than just being a laggard in the EU integration process. Most important, it is far more dollarized.
The pervasiveness of unofficial dollarization greatly affects Croatia's choice of exchange rate regime. Croatian depositors overwhelming prefer to hold their deposits in foreign exchange (mainly euros, but also U.S. dollars). Croatian banks, to avoid currency mismatch, issue loans that are indexed to the exchange rate. Although this practice avoids overt currency mismatch on banks' balance sheets, it creates an indirect risk of heightened default if the exchange rate depreciates.
This balance-sheet effect is a familiar problem in dollarized economies, and it is a strong reason for limiting exchange rate flexibility. Mishkin (1996) argues that under high dollarization, monetary policy must be concerned with financial stability first, and only secondarily with output stabilization. This approach has been followed in Croatia. The abandonment of the output stabilization function of monetary policy would thus seem to be a cost...