As Marina Klepo/Novac writes on the 8th of June, 2020, although two months ago it indicated the possibility of Croatia postponing its entry into the ERM II exchange rate mechanism, Fitch now believes that the process of the country’s entry into the Eurozone, a prerequisite to which Croatia had to agree in order to gain EU membership, will proceed as planned, despite the disruption caused by the ongoing coronavirus crisis.
In the latest report on the state of the Croatian economy, Fitch expresses its expectations that institutions will continue with the process of joining the exchange rate mechanism and the banking union. According to the rating agency, Croatia will formally request entry into the banking union and ERM II, a waiting room for entry into the Eurozone, in the third quarter of 2020’s summer months, where it must spend at least two and a half years.
Nineteen reforms
As for Croatia, it has done its homework in full: the government reported a month ago that it had fulfilled the action plans of nineteen reform measures, and recently the CNB also reported that five banks have successfully passed the control tests carried out by the European Central Bank. According to Croatian leaders, the government will soon inform the competent European institutions about the implementation of all of the requested measures, and the ECB should inform the Eurozone member states about the results of the assessment of the quality of the assets of five Croatian banks.
Their positive response is expected by mid-July, after which the procedure requires the sending of a formal request to join the ERM II and the establishment of close cooperation between the CNB and the ECB. According to unofficial information, this process should be completed in the coming months.
When Croatia enters the ERM II, it primarily regards the determination of the exchange rate at which the domestic currency (kuna) will be replaced by the euro in the future, as well as the range of permissible fluctuations around the central parity.
The range of fluctuations should not exceed plus-minus fifteen percent. In the past two decades, the kuna has fluctuated plus or minus five percent around an average of 7.42 kuna per euro, so it is expected that the central exchange parity will be determined approximately around that market level. When it comes to joining the banking union, this means that the ECB will decide on the beginning of close cooperation with the Croatian central bank and over which banks it will conduct direct supervision. The remaining, less significant banks will be supervised by the CNB on behalf of the ECB.
Healthy banks
Given the long-term decent health of Croatian banks, the ECB’s assessment that they are well-capitalised and that they can withstand a very strong negative economic shock is not particularly surprising. The assessment included Zagrebacka banka, PBZ, Erste bank, OTP and HPB, and consisted of asset quality control (AQR) and a stress test, ie, shock resistance testing in a scenario involving a recession, unfavourable interest rate movements and other risks.
Shock resistance testing has shown that even in the worst case scenario, the rate of regular capital would not fall below the prescribed minimums and regulatory requirements.
The Maastricht criteria
If Croatia successfully takes the first step on the road to Eurozone entry, a new question that will arise is how long it will remain in the exchange rate mechanism and when will the euro will really come into everyday use here. The experience of other countries shows that this period can vary from two and a half years, as was the case with neighbouring Slovenia, to 11 years, as experienced by Lithuania, which remained in the ”waiting room” from 2004 to 2015.
In the case of Croatia, Fitch notes that the issue of deadlines for Eurozone entry remains open given its difficulties in meeting the Maastricht criteria, especially the one related to weak economic growth and the medium-term outlook for public debt. This year, Fitch estimates, public debt will reach 86.2 percent of GDP.
With economic recovery, it is believed that it will be possible to achieve the prescribed pace of public debt reduction, which is one twentieth of the difference between the actual amount of public debt and the limit of 60 percent of GDP, which means just over one percentage point per year.
However, the very prospect of joining the Eurozone is an important positive signal that also affects Croatia’s credit rating. If everything goes according to plan, Fitch states in its report that in the time since entering the exchange rate mechanism and switching to the euro, it intends to increase Croatia’s long-term rating by two notches.
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