Box 1 Cyclical movement of loan quality in Croatia

An elevated level of non-performing loans (NPL) in the loan portfolio of banks has a negative effect on the stability of the financial system and through several channels hinders the financial intermediation process. According to a report by the ESRB, non-performing loans increase insecurity regarding the stability of the banks' operations. This, in turn, is reflected in the higher cost of banks' funding sources on the market, and, consequently, in the potentially higher price of loans on the asset side, which ultimately impedes lending to the real sector. Furthermore, non-performing loans require a large amount of capital and operative resources of banks that could alternatively be used for granting new loans, which, again, has a negative effect on lending to the real sector. Moreover, a high level of non-performing loans is also a signal of problems in the real sector and its reduced capability of debt repayment. All of the above negatively affect potential economic growth.

Economic literature concerning the issue of non-performing loans, such as a report by the EU Council, identifies the life cycle of non-performing loans, which consists of four phases. The phases can be qualitatively defined based on the share of non-performing loans in total loans (the non-performing loan ratio, NPLR) and the non-performing loan coverage level (Figure 1), as the combination of these two indicators is well suited to describe the life cycle of non-performing loans. In the observed period from 2001 to the end of June 2017, the Croatian banking system went through all four phases of the NPL life cycle (Figure 2). In early 2001, the system was still recovering from the banking crisis that had begun in 1998, and the data suggest that the period could correspond to the third phase of the NPL life cycle, i.e. to the phase characterised by the decreased level of non-performing loans with a still high coverage ratio. A significant loan expansion ensued as a result of economic growth and transferred the system to the fourth phase of the life cycle, where the non-performing loan ratio stood below five percentage points. The global financial crisis that broke out in 2008 was quickly reflected in the deterioration of the quality of the banks' loan portfolio in Croatia, causing the non-performing loan ratio to increase by nearly 12 percentage points in only five years and exceed 17% at end-2014, after which the system gradually entered the third stage of the aforementioned life cycle.

Figure 1 Schematic representation of NPL life cycle

Source: CNB processed data based on a report by the EU Council.

Figure 2 NPL life cycle in Croatia

Notes: NPL life cycle distribution in Croatia is a CNB assessment based on qualitative definitions of particular phases. The vertical broken line indicates the entering into force of the Decision on the classification of placements and off-balance sheet liabilities of credit institutions (OG 41A/2014).

Source: CNB.

A more detailed analysis of the developments in the non-performing loan ratio and its components reveals the main patterns of change between particular life cycle phases in the recent period (from 2011 onwards). In the 2011-2014 period, the non-performing loan ratio grew by an average of 1.44% annually and the rise was primarily a result of the deterioration in the quality of the loan portfolio, i.e. of the accelerated growth in the volume of non-performing loans (Figure 3). The rise in the coverage of non-performing loans intensified in early 2014 when the Decision on the classification of placements and off-balance sheet liabilities of credit institutions (OG 41A/2014) entered into force, based on which the banks are required to progressively adjust values of exposures depending on the number of delinquency days. Consequently, the coverage of non-performing loans rose by 18 percentage points from end-2013 to end-2016, exceeding 60%. Growing costs of loan value adjustments in the observed period reduced the gap between the book value and the economic value of non-performing loans, motivating the banks to clean up their balance sheets. However, structural difficulties in resolving the issue of insolvency hampered the banks' internal resolution of non-performing loans, as suggested by the World Bank assessment of the ease of resolving insolvency pointing to the relatively low efficiency of the practice in Croatia compared with other CEE countries. The appearance of enterprises specialised in the collection and management of claims increased the demand for the purchase of non-performing exposures of banks. Preconditions for the intensified sale of non-performing exposures of banks were thus created on both the supply and the demand side. The process particularly gained pace from 2015 onwards, when HRK 11bn of non-performing exposures of banks were sold on a cumulative basis. Write-offs of non-performing loans that are predominantly related to sales in the observed period thus became the main determinant of the trends in their share in total loans. Furthermore, the quality of the loan portfolio improved in 2016^[3], suggesting that the creditworthiness of the real sector improved as a result of positive trends in the real economy and reinforced recovery (Figure 3). The contribution of the reclassification of non-performing loans in the first half of 2017 was positive, primarily under the influence of the deterioration of the loan portfolio quality in the non-financial corporate sector, which, in turn, was predominantly caused by the materialisation of the credit risk of Agrokor Group. In the household sector, the loan portfolio continued to recover.

Figure 3 Decomposition of the non-performing loan ratio change in the recent period

Notes: The symbol * indicates a semi-annual change, i.e. the change from 31 December 2016. The positive contribution of the reclassification of non-performing loans indicates deterioration in loan portfolio quality and vice versa.

Source: CNB.

Although the aforementioned trends are encouraging, certain economic sectors and banks themselves are still under increased pressure from credit risk. Notably, banks in Croatia still have a relatively high non-performing loan ratio compared with peer countries (Figure 4). Realised credit risk is higher in the non-financial corporate sector, where the non-performing loan ratio stood at 27.1% at end-June 2017. Despite the high level, it is noteworthy that positive trends in resolving the issue of non-performing loans are particularly pronounced in the non-financial corporate sector and have continued over the first half of 2017 despite the materialisation of credit risk of the Agrokor Group. Still, the outcome of the concern's restructuring remains uncertain, and due to its significance for the entire economy, the continuation of positive trends recorded in the non-financial corporate sector is open to question.

Resolving the issue of non-performing loans is one of the preconditions for achieving sustainable credit growth, and the banks' initiative to resolve the issue and the improvement seen in the quality of the loan portfolio provide a positive contribution to such efforts.

Figure 4 Comparison of NPLR and NPL coverage among EU member states

Notes: Values of regional indicators were calculated as the asset-weighted average of indicators of particular countries. According to available data, CEE countries include: BG, EE, HR, HU, LT, LV, PL, RO, SI and SK, while EU countries, in addition to the aforementioned ones, include: AT, BE, CY, DE, DK, ES, FI, FR, GB, GR, IE, IT, LU, MT, NL, PT and SE.

Sources: CNB and ECB (Consolidated Banking Data).

Note on methodology

Decomposition of the year-on-year change in the non-performing loan ratio (NPLR) is estimated as:

where (NPL write-offs)_t indicates the amount of NPLs written off in year t, and (NPL reclassification)_t indicates all other changes in the volume of NPLs occurring in year t. Contributions of NPL write-offs and reclassification are estimated by considering the volume of total loans fixed, i.e. the same as in the previous year, in order to exclude the effect of change in the volume of total loans, while the contribution of the change in total loans was estimated as the remaining amount up to the recorded change in the NPLR in year t not included in the two contributions mentioned above.

Analytical annex: Risk of non-financial corporations providing accommodation and food services

Over the last fifteen years, the Croatian economy underwent periods of intensive growth, prolonged recession and gradual recovery. However, such dynamics affected accommodation and food service activities, through which services in tourism are provided, to a somewhat lesser extent. Notably, in the 2002-2016 period, the share of the number of corporations and the share of persons employed in the aforementioned activities in the total employment in the non-financial corporate sector almost doubled as a result of continuous growth. At end-2016, the share of persons employed in accommodation and food service activities stood near 7%, and the share of the number of corporations such services hovered around 8%. In absolute terms, this accounts for over 63,000 persons employed in over 9,200 corporations. The economic significance of the activities is visible in the rise in the share of exports of services in GDP (mainly attributable to tourism) from 21.5% in 2002 to 26.8% in 2016, as well as in the increase in the direct share of accommodation and food service activities in the total gross value added, from 4.0% in 2002 to 5.5% in 2015.

Still, from the financial stability perspective, the rise in the significance of these activities makes the economy more exposed to changes in demand for tourism services via multiplicative effects, while excessive investments financed through loans may create an unstable capital structure which could lead to a rise in the share of non-performing placements of banks should circumstances change. Accordingly, the aim of this analytical annex is to provide insight into the degree of risk in the sector.

The majority of net revenues in the activities were generated in several larger (primarily hotel) corporations. Almost three quarters of total net revenues in 2016, i.e. over HRK 16bn, was generated by the 7% largest tourism corporations (approximately 650 corporations). However, compared with other activities in the non-financial corporate sector, the aforementioned concentration is not high. It is necessary to note that the introduction of fiscalisation in 2013 contributed to the rise in registered revenues of corporations in the sector (by nearly 17%), particularly in small enterprises. The introduction of the e-visitor system in 2015 also improved the registering of revenues. The continuous real growth in the revenues of small enterprises and the rise in the number of newly-established corporations reduced the concentration in the sector.

Figure 1 Concentration of net revenues of corporations providing accommodation and food services (by years) and by activities in 2016

Note: The highest concentration measured by the Gini index is reported as 1, while 0 denotes an even distribution of net revenues per corporation.

Sources: CNB and FINA.

Growing revenues and profitability over the recent years contributed to the decrease of risk in the industry. In 2016, ratings^[4] of corporations providing accommodation and food services improved substantially, and the pace of their improvement in the period exceeds the dynamics of the improvement of the total non-financial corporate sector's rating. In 2017, the ratings stabilised, the outlook being for a further slight improvement.

Good business performance tends to bring about a decrease in financial leverage through the simultaneous increase in capital and decline in total liabilities (Figure 2). Compared with the corporations providing the same services in tourism-oriented EU countries, Croatian corporations have a lower level of debt than EU corporations and are better capitalised, resulting in lower financial leverage, which has been decreasing rapidly over the past several years. Similar financial leverage is found in Spanish corporations, coupled with a slightly lower level of capitalisation, while Austrian corporations have the smallest share of capital in balance sheet structure, resulting in the highest financial leverage. Lower financial leverage in the industry, as one of the measurements of risk, points to the lower potential risk of corporations in the sector on an aggregate level than in peer countries.

Figure 2 Financial leverage of corporations providing accommodation and food services in Croatia and EU countries

Note: Financial leverage has been calculated as the weighted average of the ratio of total liabilities (capital excluded) to capital * 100%.

Sources: CNB, ECCBSO and FINA.

The gross profitability of Croatian corporations (before interest, taxes, depreciation and amortisation: EBITDA) in tourism is the highest among peer countries, and also higher than the average of the entire non-financial corporate sector (Figure 3). On the other hand, net profitability is on average similar to other observed countries: from the values which were comparable to other observed countries before recession to the negative values recorded in the period from 2009 to 2011; however; in the post-recessionary period, net profitability recovered swiftly and surpassed the profitability of the industry in other countries (Figure 4).

Figure 3 Gross profitability of corporations providing accommodation and food services in Croatia and EU countries

Notes: Gross profitability has been calculated as the weighted average of the ratio of EBITDA to operating revenues * 100%. EBITDA = earnings before interest, taxes, depreciation and amortisation.

Sources: CNB, ECCBSO and FINA.

Figure 4 Net profitability of corporations providing accommodation and food services in Croatia and EU countries

Notes: Net profitability has been calculated as the weighted average of the ratio of net operating income to operating revenues * 100%. Net operating income = difference between operating revenues and operating expenses.

Sources: CNB, ECCBSO and FINA.

The reasons for the notable difference between the profitability of Croatian corporations presented by means of gross and net profitability (in both tourism and the entire non-financial corporate sector) primarily lie in the high cost of amortisation relative to operating revenues (12-16% for Croatia versus 5-10% for other countries) and in the higher share of interest rate expenses in operating revenues in the preceding period, which, however, decreased considerably in the recent period (these expenses accounted for 7-8% of revenues in the earlier years and about 4% in the recent years, compared with shares of 2-3% in other countries observed). The high cost of amortisation is a result of the higher share of tangible assets in the asset structure of Croatian corporations (around 50%), particularly in tourism (70-80%), as well as of accounting policies that allow accelerated amortisation rates. In Croatia, these rates can reach 10% for real estate (10-year amortisation) or 5% as the regular amortisation rate (20-year amortisation), while in other EU countries, prescribed real estate amortisation rates mainly amount to 4%, and can only reach 10% in exceptional cases (depending on the country and type of real estate).

In all analysed countries there is a noticeable trend of a rapid rise in the coverage of interest rate expenses^[5]: in Croatia, it has increased up to seven times since 2010; in Spain and Italy it has almost doubled, and in Austria, it is now 1.5 times higher. A significant rise in the coverage of interest rate expenses since the recessionary period suggests that various mechanisms of hedging against interest rate risk and stabilisation of operations were introduced, such as finding more favourable sources of funding (including from own operations), debt reduction, corporate management of liquidity risk and other risks and the gradual increase of capitalisation. The global decline in interest rates on sources of funding and the rise in revenues in the post-recessionary period from 2012/2013 contributed additionally to the trend.

Corporations providing accommodation and food services in Croatia and EU countries clearly display signs of a strong recovery from recession and stabilisation of operations, with Croatian corporations showing the most substantial growth compared with corporations from other observed countries in most indicators. This may, most probably, be attributed to the fact that Croatia is currently an attractive and safe holiday destination.

Current developments at sector level do not point to specific risks for corporations as the several-year increase in turnover was used to improve the corporations' capitalisation. Nevertheless, the analysis at sector level need not necessarily apply to developments in particular corporations. In addition, regardless of the capital structure, the ability to generate revenues, which depends both on the service provider and the perception of Croatia as a tourist destination, is one of the most significant determinants of stability of corporations in the sector. Therefore, credit institutions should approach each project individually rather than observe only the good performance of the entire activity in the preceding period. Finally, a significant portion of investments in tourism is made outside the non-financial corporate sector, for which there are no publicly available data on creditworthiness and which are not analysed in this analytical annex. Still, considering the rise in the number of private accommodation units over the past several years, it is necessary to exercise care in approaching the analysis of each project when deciding on the financing.