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Global financial crisis and related country-level financial sector disasters: The case of microfinance in Croatia

The economic policy regime that has dominated global economic policy making since the late 1970s is often termed the Wall Street-neoliberal policy regime (also called the ‘Washington consensus’). This policy regime was the preferred choice of the US government, the World Bank and IMF, and Wall Street’s (now deceased) high-profile investment banks (see Gowan, 1999 ; Stiglitz, 2002 ; Elliot and Atkinson, 2008). One reason for this preference, we are now coming to realise with greater clarity, was that it was a policy regime overwhelmingly meant to primarily benefit the richest developed countries and their key institutions and individuals, especially in the USA, far more than it was meant to benefit the poor countries actually expected to adopt it (see also Oyelaran-Oyeyinka and Rasiah, 2009). Of course, many local economists in these countries, as well as many high-profile international economists with experience of developing countries (see for example, Taylor, 1994 ; Amsden et al, 1994 ; MacEwan, 1999), were not unaware that such a policy regime had effectively destroyed many developing countries in the past. But such realists/sceptics had little effective power to stop the policy juggernaut coming from the powerful western countries. Typically, by offering high financial rewards, study tours to prime institutions in the west, juicy consultancy work, prestigious contacts and other attractions, a local policy elite was carefully nurtured in each country willing to ‘fight from within’ on behalf of the Wall Street-neoliberal policy regime. However, if serious resistance was encountered in developing or transition countries, then the Wall Street-neoliberal policy regime could still be imposed through conditionality and other pressure techniques. Today, things have changed dramatically. The Wall Street-neoliberal policy regime is now effectively dead (though resuscitation is being attempted by some die-hard market fundamentalist institutions and individuals, especially in the USA). The Wall Street-neoliberal policy regime is universally seen as directly responsible for the most serious worldwide economic crisis since the Great Depression, which was itself, of course, a direct outcome of an almost identical extreme free market policy regime as the Wall Street-neoliberal policy regime (see Polanyi, 1944: Galbraith, 1955). Thanks to the simultaneous popping from late 2007 onwards of a number of bubbles in the US economy (credit, housing, investment, speculation, hedge fund, etc), a ‘perfect storm’ of economic problems was set in motion. The US economy is now effectively bankrupt and currently desperately struggling to rescue huge swathes of the American industrial and financial system through Keynesian-inspired spending plans, bail-outs and state ownership. The US trade deficit and national debt are largely financed by the Chinese government’s purchase of (supposedly safe) US Treasury bonds and other assets. The US government’s closest ideological ally since the Reagan-Thatcher axis of the 1980s, the UK, is the other country that has most dramatically declined since late 2007. Since late 2007 it has had to effectively nationalise its entire banking system (raising public debt to levels last seen just after the Second World War), while also bailing out large areas of the economy in order to stave off potentially massive job losses. Several previously high-performing ‘role model’ economies that, like the UK, also chose to closely follow Wall Street-neoliberal policies have already effectively collapsed (Iceland), are on the verge of collapse (Ireland) or have registered dramatic economic decline (Spain). The other major world economies much less enamoured with the Wall Street-neoliberal policy regime have also been plunged into a vicious economic downturn (Japan, Italy, France, Germany). After some delay, the fast developing and transition countries have now begun to feel the pain, with huge problems registered in Hungary, Ukraine, the Baltic states, Russia, China, South Korea and elsewhere. The least developed countries are also expected to decline substantially moving into 2009. From 1995 onwards Croatia was pretty much a full and willing participant in the Wall Street-neoliberal global policy experiment, notwithstanding some hedging and backtracking on the part of those previously fully enamoured (for example, see Šonje and Vujčić, 2003). The full impact of this policy regime choice has yet to be felt in Croatia. However, there are few optimistic portents that suggest that Croatia will avoid a serious economic downturn. This paper looks at one policy area where the flawed Wall Street-neoliberal policy regime played itself out in Croatia. As elsewhere in South East Europe (Bateman, 2003), after 1995 the Croatian government was strongly recommended to offer its full support for the concept of microfinance. Two subsequent developments are noteworthy. • First, the international donor community arrived to help establish a number of functioning microfinance institutions (MFIs). After some delays due to a lack of support from the then Croatian government, three MFIs were established in Croatia with international donor funding – DEMOS, MikroPlus and NOA. All three MFIs received significant international donor funds in order to promote very small-scale entrepreneurship among the so-called ‘entrepreneurial poor’. • Second, after 1995 the Croatian government immediately began to restructure the banking system. According to the Wall Street-neoliberal policy regime, this called for the full privatisation of the main commercial banks, ideally to powerful foreign banking groups. The pressure on the Croatian government to implement this core aspect of the Wall Street-neoliberal policy regime was significant. The World Bank and IMF, of course, operated on the basis of full privatisation of the banks was absolutely imperative. Other institutions also got in on the act of persuasion. For example, through the UK government’s DFID, advice to the Croatian Ministry of Finance was to move very rapidly towards the full privatisation and sale to foreign-owned commercial banks of Croatia’s main banks, and to avoid any contact whatsoever with seemingly better policy models - especially the very positive experience emerging in neighbouring Slovenia where a state-led/policy-based banking model was highly successful in supporting SMEs (for example, see Chapman et al, 2008). The predictable result was that the newly privatised and largely foreign-owned commercial banks in Croatia massively jumped into the provision of simple household microloans. Rising from almost nothing in 2000, by 2006 the volume of household microloans had begun to approach 35% of GDP, probably the highest level in all of Eastern Europe (Kraft, 2006). Discounting the proportion of household microloans aimed at house purchase (around 30%), a very large amount of financial support has been packaged up into what we might call ‘traditional’ microloans (up to €5, 000) that can be used for virtually whatever use the borrower wishes – consumption spending or simple income-generating projects. So has this very large dual expansion of microfinance in Croatia since 1995 helped to promote sustainable economic and social development? We think not. Instead, we would argue that this microfinance largesse has been a manifestly deleterious factor in Croatia’s post-conflict development economic and social development trajectory. There are two main inter-related problems. First, empirical research by the authors around the three MFIs in Croatia (see Bateman and Sinković, 2007, 2008) shows that, very much as elsewhere in South East Europe (see Bateman, 2003, 2007, 2008), MFIs operating in Croatia have largely played a destructive role in terms of promoting sustainable development and poverty reduction in Croatia, viz: • A local over-supply of the simple goods and services produced by new MFI-supported microenterprises has tended to precipitate a decline in the local prices of these products and services, which then negatively affected the operating margins and incomes of already struggling non-client small-scale microenterprises operating in the same local markets. The ‘fallacy of composition’ dilemma, a staple of year one University economics courses, was clearly not recognised in this context. • Employment displacement effects have been very high, meaning that new microfinance-induced microenterprises simply displaced employment in other non-client microenterprises producing the same basic goods or services. Net employment has thus been very limited. • Significant numbers of MFI clients ultimately failed (probably the majority ) and many of these poor(est) individuals ended up in deeper poverty than before they accessed their microloan. We know that failure of a microenterprise often necessitates having to repay the original microloan by liquidating family assets - family savings, apartments, family land, and so on – as well as going even further into debt. This is, of course, why failure rates appear quite high in Croatia, but repayment rates nevertheless remain impressive. But what this also means is that very many of the poorest individuals who end up failing in their microenterprise venture are therefore plunged into even deeper poverty and asset insecurity than before. Moreover, we found that some methods of repaying a microloan signify very little real impact indeed - in the dairy sector, for example, those that just about survived only did so and repaid their microloan by tapping into Croatian government subsidies for small-scale dairy producers. • The construction of sustainable and efficient (i.e., minimum efficient scale of operations) industrial and agricultural sectors tends to be held back by microfinance. We illustrate this with the example of the dairy sector in the Karlovac region. A well-functioning dairy sector in the region would have been a major boost to this region’s chances of recovering from the war. However, little progress was made thanks to the artificial market chaos brought about by the poverty-push entry of tiny microfinance-supported producers, who absorbed market demand away from potentially sustainable producers, thus raising their unit costs and introducing uncertainty at precisely the wrong time. Moreover, the Croatian government also lost valuable financial resources (and time) thanks to the subsidies made available to ‘3-cow and above’ dairy farms that quite predictably failed to survive. • There was an important loss of local social solidarity. This largely transpired when it became clear that all three MFIs were quietly and carefully converting into financial institutions privately owned by their key employees and close associates. This is taking an institution out of the (potential) control of the community and into the hands of small group of individuals who are gradually coming to see their own personal job security and financial enrichment to be the operative goals of the MFI. In addition, reflecting a disturbingly unethical trend in the microfinance industry worldwide (re: dramatically in the case of BancoCompartamos in Mexico – see Bateman, 2009), significant donor grant funding offered to the three MFIs ‘to support the community’ is in process of being privatised into the personal ownership of the handful of employees and their associates most active in all three MFIs. Second, while the theoretical and empirical finance literature has focused almost exclusively on enterprise credit, Beck et al (2008) found that more than half of the credit extended by banks to the private sector in a sample of 45 developing and developed countries is to households. Given finite financial resources, this raises the obvious issue of opportunity cost. Domestic savings mobilisation channelled towards household microloans will mean, among other things, that other sectors are therefore effectively denied bank credit. Crucially, Beck et al, (2008) find this household microloans trajectory to be sub-optimal. Yet this trajectory is indeed what has been occurring in Croatia since around 2000. Faced with the choice of channelling local savings towards very risky and low profit SME projects, or else towards high profit/low risk household microloans, Croatia’s private commercial banks have widely opted for the latter. However, as predicted (Bateman, 1995) and as transpired everywhere in South Eastern Europe (Bateman 1999, 2008), this effective diversion of domestic savings into simple ‘Grameen Bank-style’ microfinance programmes and away from industry-based and technology-/innovation-driven SME development has been quite deleterious for Croatia’s economy. And as a host of international organizations continue to report (see OECD, 2007), Croatia’s SMEs continue to have major problems accessing affordable finance. In terms of new start-ups, expansions and for routine productivity-raising investments (e.g., equipment, business accommodation, training), the situation is that few financial institutions want to develop a major loan portfolio here. It is therefore no surprise to find that the Croatian SME sector has, in general, failed to develop through incremental reinvestment and industrial upgrading. Moreover, this microfinance-led strategy entirely contradicts the development experience of all developed countries and the richest developing countries of the last forty years. As Ha-Joon Chang (2002, 2006, 2007), Alice Amsden (2001, 2007) and Erik Reinart (2008) all vividly point out, today’s rich developed economies and the more recently wealthy East Asian ‘Tiger’ economies all managed to succeed in sustainably reducing poverty not through microfinance and the resulting volume of simple informal sector microenterprises, but by deliberately steering a very large percentage of national financial resources (i.e., domestic savings) into relatively technology-intensive microenterprises and SMEs and larger business projects located in potentially growth-oriented markets. Finally, and of most immediate concern today, there are growing fears that a microloan repayments crisis is around the corner (see Coricelli, Mucci and Revoltella, 2006). The current reversal in global economic fortunes is for sure undermining those income-generating projects started in Croatia with household microloans. Moreover, the fact that most (around 80%) household microloans are Euro- or Swiss Franc-denominated, and thus subject to inevitable adverse exchange rate movements against the local currency, means that today average monthly repayment rates are actually moving higher. As Kraft (2006) emphasises, this household microloan risk is not confined to Croatia by any means. But even if current repayment rates are nevertheless maintained in Croatia in the face of deteriorating economic conditions, which Kraft (2006) reports so far seems to be the case, we also know that this simply means that many of those individuals in micro-debt are being forced to repay their microloans through other means – such as going into even further indebtedness (multiple microloans are rising), depleting other important financial flows (e.g., remittance income, pensions) or else liquidating important family assets (e.g., savings, land, buildings, apartments, etc). However, all three ‘fall-back’ methods of microloan repayment imply that the poor in Croatia are being stripped of many of their most important family assets and income flows at a time when they will need them in order to survive the coming financial firestorm intact. All told, as even the Croatian National Bank (HNB) is now starting to realise (for example, in terms of stimulating consumer goods imports and undermining the BoP, see Kraft, 2006), we suggest that very much damage has been done to the Croatian economy through toleration of the emphasis upon household microloans. We conclude that microfinance has likely been a seriously deleterious factor in the post-conflict economic and social reconstruction and development of Croatia.

Local development; microfinace; financial crisis; finacial development

Rad je kao poster prezentiran na skupu 8th International Conference "Challenges of Europe: Financial Crisis and Climate Change", održanom od 21.-23.05.2009.g., Brač, Hrvatska.