 On the 1st of January 2023, Croatia adopted the euro and with it, it became the 20th member of the euro area. The country has shown great commitment along its path towards the euro, which hasn't always been easy. After joining the EU in 2013, Croatia made significant progress in getting its economy ready to adopt the euro as its official currency. But how much do you know about Croatia's economy and about the steps it needed to join the euro family? Well, that's what we'll be talking about today, in what is the second episode in our mini-series on Croatia's adoption of the euro. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. I'm joined here in the studio by Martin Beisterbott, who works in our economics department and was part of the team dealing with Croatia's adoption process. Martin, great to have you here on the podcast. Thank you for having me here. Now, can you kick things off a little bit by telling us something about Croatia's economy? I mean, most of us probably know the country as a tourist destination, but I've no doubt that there's much more to it than that, right? Absolutely. I think what's interesting is that Croatia is a small and open economy, highly integrated with the euro area. Around 4 million inhabitants, it's around half a percent of the euro area's GDP, so it's a small economy. But its structure is kind of, say, broadly similar to what we have in the euro area. But one thing that stands out, I think what's interesting to mention is the important role of tourism, as you already said. It dominates the services sectors. Actually, Croatia is one of the countries that depends most on tourism as a source of revenue in the European Union. And so around a fifth of its GDP is accounted for by tourism. And that has, of course, also a sizable influence on other sectors of the economy. And maybe one more point that I think is relevant, especially for euro adoption, is the fact that Croatia has a tradition of stable exchange rates. It created its national currency in 1994. It was, you know, it pegged the Kuna, the previous currency, to the German mark back then and after that in 1999 to the euro. So it has that tradition of stable exchange rates, which is important for the euro. Okay, so as you mentioned, they tied or pegged their previous currency, the Kuna, to the euro. They've been doing that since 1999. And that makes me wonder whether, in fact, they already had quite strong ties to other euro countries before they even adopted the currency themselves, particularly given the fact that they had already been in the EU for 10 years. Yes, absolutely. Croatia has had very strong ties with the European Union, with the euro area. Financial ties, for example, the banking system, for example, a large part of the banking system, the vast majority of bank assets are owned by foreign banks, banks from the euro area, especially from Italy and Austria. So that is definitely one factor. Another one is trade linkages. The euro area is Croatia's main trading partner. And in terms of debt, that's definitely a factor that stands out, where you see that we've seen a very high degree of what is called euroization. So the facto use of the euro in daily life, for example, in the issuance of debt, for example, public debt outstanding is around 70% of that is nominated in euro. That's very high for a country that used to have a different currency. So lots of links there, trade, banks, also this debt in euro that you just mentioned. So why didn't Croatia adopt the euro earlier? I mean, it's clear there were lots of links there. What was their path to joining like? Yeah, joining the euro is a long process, especially in terms of, say, convergence, economic convergence takes time. Croatia came from, say, a different starting point after independence. They had to go through an economic transition towards a fully functioning market economy. And that takes time. Business cycles to converge, that also takes time. Set up the institutions for the euro, for the European Union takes time. So when Croatia joined the EU back in 2013, it automatically agreed to adopt the euro. Like that is in principle the case for every country that joins the European Union. Now, when a country says that it's ready to adopt the euro, then the next step is that the European Commission and the ECB need to assess whether the country is ready for euro adoption. So that is done based on a number of criteria, so-called convergence criteria. Okay, let's just pause on those ones a minute, these convergence criteria, because these kind of requirements, right, that the country has to fulfill in order to join the euro area. Can you just explain a bit what they are? Yeah, so there are economic criteria and there are legal criteria. Now, let me here focus on the economic criteria. That's, first of all, the need to have stable prices. That means that inflation in the country, the average inflation rate, cannot be more than 1.5% above the rate of the three best performing EU countries in terms of inflation. The logic of that is clear, because you need to have price stability to successfully participate in the euro area. So that's basically the three with the lowest rate of inflation, essentially. Correct, correct. And in the case of Croatia, that inflation rate was something like 4.9%, so below that reference value. So that is one factor. Now, the other factor, the other criterion that's very important, is the need to have sound public finances. And in EU jargon, that means not having an excessive deficit. So that essentially means that a country cannot have a deficit that is more than 3% of its GDP, and it needs to have a debt ratio, public debt ratio of less than 60% of GDP. It's a little bit more subtle than that, but essentially that's what a country needs to have. And that is crucial, because once you're in the euro, you don't have your own monetary policy anymore, you don't have your own exchange rate policy anymore. So you need sound public finances, for example, with fiscal buffers to deal with economic downturns. So the logic of that is very clear. And it's also in the interest of the euro area as a whole to have sound public finances, right? Because if that's not the case, it can have spillovers to other euro area members. We've seen that in the past, and that is definitely... So that is the essence there of the public finances criteria. Now, the other one is exchange rate stability. So a country needs to have participated in the exchange rate mechanism, the ERM-2, for at least two years without devaluing its currency. And that is in a way, say, an intermediate stage between, say, fully flexible exchange rates and having the euro, because it's a system of, in principle, fixed exchange rates, but they can be adjusted. And there's a fluctuation margin of up to 15% around that central rate. So it's a good, say, preparatory phase for having the euro. So for at least two years, countries need to be in there. And then we have the long-term interest rate criterion. So their countries need to have low long-term interest rates, in a way, as an additional test, an additional check to see that the financial markets are convinced that the country has converged, that convergence is sustainable. And that sustainability is a key concept that we always emphasize. Convergence needs to be sustainable. Also in the medium term, especially, given that euro adoption, of course, is a structural change. It's a permanent change. It's very important that a country can continue to converge also after it has adopted the euro. And then, as I briefly mentioned, there's also the legal framework, which is essentially about the independence of the central bank and a couple of other things. But that is, we look at that as well, in our convergence reports that we do every two years or upon the request of a country when a country wants to adopt the euro. Those are the criteria. Okay, and Croatia officially fulfilled these criteria in June 2022, right? Correct. The stable prices, sound public finances, stable exchange rate, and low long-term interest rates, plus making sure that they can keep all that up after adoption. Yes. Now, let's turn to look at Croatia's economy today. How's it doing? How has a country handled the shocks stemming from the pandemic and also from Russia's awful war in Ukraine? It's true that we've had a few major economic shocks in the past few years, like everywhere in Europe. Of course, Croatia has been hit particularly hard by those as well, being a country that's dependent on tourism. Of course, it's no surprise that the corona pandemic hit the country hard. Real GDP went down by something like eight, nine percent back in 2020 when the pandemic came, but it recovered quite quickly. Actually, it grew by around 13 percent in 2021, thanks to tourism, but also due to strong consumption spending investment. It actually remained one of the fastest growing economies in the EU in 2022. Oh, wow. So that went quite well. In terms of, say, the more recent shock, so the Ukraine war, the country has relatively limited, say, direct links to Russia. So that is not the main channel through which it is exposed, but obviously it is affected indirectly. So that is definitely something that is affecting the higher energy prices triggered by the conflicts, for example, are affecting Croatia as well. Inflation rose as a result of that, and its energy prices, food prices are up, and even though fiscal measures have, at least in the short term, have been able to kind of dampen that impact, but it's clear that that is, of course, a challenge, and like it is everywhere, it's broadly in line there with the rest of the euro area, the increase in inflationary pressures that we're seeing. But what I think is interesting there is that, despite those shocks that we've seen, that that didn't really impact Croatia's capacity to fulfill the criteria for euro adoption. Okay, so similar picture to what we're seeing in other euro area countries, but indeed it hasn't had an impact on their ability to join the euro, which is obviously good news. Now we've talked a lot about everything that Croatia has done to join the euro area. Let's turn to talk about the people who actually use the currency. What has it meant more concretely for Croatians in their everyday lives? I think the most concrete thing is the fact there is no risk of currency fluctuations vis-a-vis the euro. So that means that people do not need to change their currency anymore when they go abroad. It also means that tourists that come to Croatia don't need to exchange their money anymore. They can just spend euros, and that is good for trade, obviously. But I think it's more from the literature that countries that share their currencies tend to trade more with each other. It's good for investment, for cross-border investment. So that will, in the medium term, certainly have positive impacts on the Croatian economy. So that is important. That is a clear advantage. But I think that it's more than that. It's more than just say the absence of transaction costs, the absence of exchange rate risks. As Lagarde said in an interview recently, the euro acts as a shield. It's a commitment in a way to stick together. So it's more than just the currency. It also has implications, of course, in terms of, say, the responsibilities that countries have. Economic policies in countries that share the euro cannot diverge too much. So there is also responsibility that national policymakers have to ensure the success of the euro and to ensure that the country has the benefits of the euro. So I think that the benefits, these benefits that I've mentioned, are really, say, recurring benefits that keep on coming also in the longer term. And they are clearly there for Croatia as well. Okay, that's a lot about benefits, of which there are many, as you've said. Let's talk a bit about the costs. Because we have heard, and it has been reported in the media, also outside Croatia, there have been some instances of prices being, shall we say, quietly increased during the conversion from Kuna to euro. What exactly is happening there, Martin? That's definitely something we take very seriously. And the Croatian authorities are monitoring that very closely. So there's been some discussion on that. And there have been, I think, very strong measures that the authorities have taken to prevent that risk. Prices have signed a code of ethics for the introduction of the euro. So they, in this way, were obliged to reflect, say, a fair pricing in both Kuna and euro. So since early September, for example, last year, retailers have had to display their prices in both currencies, and they will have to continue to do that until the end of the year. And if a business does raise prices in an unjustified way, it can be reported by consumers and the authorities can impose fines. So I think that there's a package of measures in place there to address that. Now, when we look at what has happened so far, and we see that, indeed, there has been some prices have increased, especially in the services sector, we see there some signs of higher prices. When we look at, say, the broader picture we can look at not just services prices, but say consumer prices in general, and we have the so-called harmonized index for consumer prices for that. That's like the basket of goods, isn't it? The basket of goods and services. Exactly, exactly. When we look at that, and we look at the January data that we now have, we see that that effect seems to have been more or less in the same order of magnitude as what we've seen during earlier changeovers. So, there is some effect, but I think it is not as alarming as reported by some media. And that's interesting because, of course, we have done this in a much more challenging environment, in a higher inflation environment. So that also makes it more difficult to distinguish between, say, justified and unjustified price increases. If prices go up in general, that's a more challenging thing to do. So it's not straightforward to identify what is an increase that is not explained by, for example, higher energy prices. Companies in general tend to adjust their prices often at the beginning of the year, so these are all challenges that complicate, say, the identification of the problem. But that's the picture we have so far. Okay, so now that Croatia has joined the Euro family, does that mean that its path has come to an end and they can just set back and enjoy being in the Euro? In a way, I would say, it's the beginning of a new path, right? It's certainly not the end of the efforts because countries, also once they're inside, they need to continue to work on reforms and those reforms are crucial to boost economic growth, to make the economy more resilient, to shocks, to downturns, to economic setbacks. I think when we look at Croatia, I think a key challenge that we see there is a challenge that stems from demographic developments. It's not unique to Croatia. Other European countries are facing similar issues, but we do see in their available reports that show that when you project the evolution of Croatia's population over the longer term, it's going to decline further and that is a challenge. It will put pressure on pension systems, it will put pressure on public finances and it will also reduce the availability of staff that could worsen shortages of staff in the labor market. So that's a clear challenge. I think another one is really productivity growth in the medium term. So it's important there to focus on innovation, string innovation, investment in new technologies. The European debate often focuses on the green transition, the digital transition. These things are obviously important also for Croatia and maybe also to broaden there the sources of economic growth beyond tourism. Tourism is clearly, it's natural that tourism is an important factor behind economic growth. Croatia simply has the natural endowments, the comparative advantage in tourism, so it makes sense that that is an important sector, but it is good to broaden those sources of growth beyond tourism into other sectors that can drive growth, that can drive productivity in the more medium term and then we have public administration. The judicial system is always a very important one because whenever there is an economic setback that's in private sector, in the private sector increase, it's important to have a well-functioning judicial system that can deal with the debt restructuring that is needed and can, you know, so that restructuring is implemented, it's done in a swift way so that bank balance sheets are cleaned up quickly. So these things are important, I think, to have in place. Well, Croatia has made a lot of progress on that front and so I think that we should be very positive on that front but it's important to continue along those lines. Now, before we wrap up, Martin, we always have a question that we ask all our guests here on the podcast and that's for a hot tip broadly linked to the topic that we've been discussing today. Now, in our previous podcast on Croatia, we talked about the animals that are on the Croatian Eurocoins. Martin, have you thought of something for our listeners? Well, you know, when I think of this process, I've seen other countries adopting the Euro in the past and, of course, we have gone through some, say, more challenging times with the Euro but one thing that strikes me when I see the Croatia adopting the Euro is really that, you know, when you look at this in a more, say, longer-term perspective and you compare that with how we started. We started back in 1999 with 11 countries and now we've essentially, you know, the Euro has doubled, almost doubled in size when you look at the number of countries that use the Euro and I think that that's really a strong sign of success. In only 20 years? In only 20 years, it shows that the Euro area is an attractive place to be and I think that's something to be proud of. So I think that that is important to keep in mind and to celebrate as a good thing that Croatia is there and it's a good thing, not just in terms of, say, the number of countries that we have but we've also seen the Euro area has strengthened over time in terms of its institutions that have been put into place. We have a supervisory system, a banking supervisory system that has been set up in something like a decade and it's well functioning. We have the European stability mechanism, for example. You know, since the first wave of countries we have added a number of changes, a number of institutional changes in the Euro area that have really strengthened the basis of the currency union. So I think that's something to be proud of. I think we often take for granted just how much has been achieved in such a short space of time. So I think that's a great note to end on. Thank you so much for joining us today, Martin. Thank you very much. Well, that brings us to the end of this episode. I want to thank Martin Beisabot from our economics department for giving us what was essentially a crash course in Croatia's economy and its journey towards the Euro. Listeners, as usual, you can check out the show notes for additional material on this topic. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard, please subscribe and leave us a review. Until next time, thanks for listening.