The Croatian Liquidity Paradox Part I: The Problems We Face

Today, we bring you a comprehensive overview of the main trends and challenges the Croatian equity market is currently facing.

As this is a very complex subject, we decided to divide this blog into two parts. In part I, we’ll focus on the challenges that the Croatian equity market faces, while in part II (which will be released in the coming period), we’ll focus on providing as many solutions as possible to these challenges.

Firstly, let’s start with the basics of any stock exchange, i.e., the companies listed on it. In 2021, there were 98 listed stocks of companies on the ZSE. There is a general expectation that this would have been an improvement over the previous years right? Well in a sense, the answer is yes but also a no. Let’s start with the no. If we were to compare the number of listed companies in 2010 when there were 233 listed companies on the stock exchange, there has been a significant reduction in the number of companies. However, it should be noted that one of the main reasons for the high number of listed stocks is the fact that Croatia had regulations that obligated all larger companies to list themselves on the stock exchange.

Number of listed stocks on the ZSE (2010 – 2021)

On the other hand, the answer is yes. The reason why is that just because a company is listed on a stock exchange, it doesn’t necessarily be a good thing (for the company or the exchange). This is because a stock that has low liquidity, high bid/ask spreads (and thus higher transaction costs), and any buy/sell order can make its price fluctuate heavily, does not contribute to the overall liquidity or growth of the exchange. Unfortunately, this is the case with a lot of companies listed on the exchange. The fact that an exchange doesn’t need a lot of listed companies is further supported if we look at the example of the Ljubljana Stock Exchange. Even though it currently has only 24 listed companies, the vast majority of the turnover occurs between the top 10 largest companies, and on average, LJSE has a larger turnover (but also liquidity) than ZSE.

A lower number of listed companies can only be taken as a negative if it has a negative impact on the number of trades, combined with a lower overall turnover on the exchange. In 2021, there were 91.599 total transactions on the ZSE, with a total turnover of HRK 2.54bn. Compared to 2010, when there were 281,875 total transactions, with a total turnover of HRK 7.32bn, we can see that the stock exchange experienced a severe decline in both the number of transactions and total turnover. Considering that equity turnover makes the majority of turnover on the stock exchange, the picture is similarly discouraging. In 2010, equity turnover amounted to HRK 5.7bn, while in 2021, it amounted to HRK 2.26bn, representing a decline of 60% in the period. Why is this important?

Total and equity turnover (HRKbn), number of transactions on the ZSE (2010 – 2021)

As the economy expands, one would also expect an expansion in the equity market, as companies grow and new companies get listed. Of course, we shouldn’t forget that the Croatian economy officially recovered from the recession in 2015, but still, the growth between the economy and the equity market should be somewhat correlated. To take a look at this, we took the equity market cap and compared it to the GDP of Croatia in the period since 2010. In total, the equity market cap amounted to HRK 139.4bn in 2021, which is an increase of 1.8% from 2010. At the same time, the GDP amounted to app. HRK 417.8bn, representing an increase of 27% since 2010. It should be noted that the total equity market cap also includes low liquidity stocks (and also changes over time as companies get listed/delisted), and if we were to remove those from the calculation, the market cap growth would have been greater, even with the lower overall market cap.

Croatian GDP* and ZSE market capitalization (HRKbn, 2010 – 2021)

*Constant prices

Why does all of this data matter exactly? It matters because however you look at it, it does show that the general trend in the equity market is negative. This brings us to the first paradox of the story, that is, one of the best ways that a stock exchange can increase its liquidity is through IPOs. The exchange needs new listings to grow, attract investors, increase its exposure and in the end, increase liquidity. This by extension, attracts new IPOs and the cycle repeats itself. On the other hand, an IPO for a company is one of the biggest decisions its management will ever make. From their perspective, getting the highest capital raised, biggest exposure, attracting the most investors, and in general, trading on an exchange that is filled with liquidity is surely a priority. Listing on an international exchange like the NYSE, NASDAQ, or any of the larger European exchanges can fulfill these goals a lot faster and more efficiently than getting listed on the ZSE. See the paradox? ZSE needs new listings to grow and attract more investors, so they can attract new companies to do an IPO. This challenge is pretty evident if we look at some of the largest Croatian companies, mainly Infobip and Rimac, who have already decided to do an IPO abroad.

Unfortunately, there isn’t much that can be done by the private sector in this regard, which brings us to the 2nd factor that can influence the Croatian financial market, and arguably the one with the most influence, i.e. the Croatian government. Currently, it holds a significant share in many publicly listed companies, examples being HPB and Jadroplov. Offering at least a small part of this share on the stock exchange through an IPO could have a positive impact. Likewise, an IPO of the privately owned government companies, for example, HEP (even an IPO of 25% share of the companies’ shares) could also have a powerful impact on the exposure of the ZSE, which would definitely increase its attractiveness.

There are two other factors that the government could influence which would help the Croatian capital market. First, (and arguably the easiest to „solve“) refers to the current capital gains tax of 10%, which lasts for 2 years after the stock purchase. Even though a capital gains tax is something that a lot of countries, especially developed countries have implemented and which has been a good source of revenue for those countries, in Croatia’s case, this seems more detrimental than helpful. This is because, by itself, the decision to tax capital gains isn’t bad. But if we were to combine it with the main problem on the exchange, i.e. low liquidity, all the tax does is reduce the incentive of investors to invest in stocks, as it means that in a way, they are tied to that stock for 2 years.

The 2nd factor that the government could influence is improving the legal framework of the whole financial market. The reason this is important is we already had a huge crisis relating to Agrokor in 2017, and its impact on the entire Croatian economy was significant. Improving the framework through more stringent transparency regulation, larger oversight by the supervision agencies, and in general, improving the laws regarding financial reporting could really have a positive impact on the market, especially when it comes to investor confidence.

The investor confidence ties in nicely with the next problem facing the equity market, which is the lack of foreign investors. As with all investors, foreign investors demand that their investments will be safe, that they will be able to trade their stocks without problems, that the companies have strong corporate governance, and that the companies’ data is available in English (which is not the case for a lot of the companies listed on the ZSE), and of course, that their investments have a chance of giving a good return. Events like the one with Agrokor, combined with the opportunity to invest abroad, lower the incentives for foreign investors to invest in Croatia.

Moving on, we took a look at the institutional investors (primarily pension funds) and their importance. As they represent major players in the Croatian capital market, they provide certain liquidity to the stocks, so increasing the number of institutional investors must be a positive thing, right? This is where we come to the 2nd paradox of the story. Even though they do provide liquidity to the market, one should also take into account their investment goals and horizons. Considering they invest long-term and are very risk averse, meaning that once they invest in a particular stock, they will rather hold it for a longer period of time than sell it, which in turn means that, even though they increase liquidity just by their sheer size, they also lower it in order to follow their investment goals. In a stagnant market plagued with low liquidity, it’s not clear if their increased number would be a benefit or a detriment.

Finally, we come to the last factor influencing the Croatian capital market, and one that could potentially have the largest influence, but at the same time, one which would also take the longest to change. I am of course referring to the Croatian retail investors and their investment habits. The vast majority of investments in Croatia are into real estate. According to the data from the ECB’s Household Finance and Consumption Survey, 86.9% of Croatian households hold some form of real estate assets. If we were to add in other forms of real assets (for example vehicles, art, etc.), then this number would amount to 96.5% of all assets held. This means that only 3.5% of all assets held in Croatia are financial assets. Let’s compare this to some countries in the EU and the Euro area average. In Slovenia, 7% of the total assets held are financial assets, in Germany, this number is 21.5%, while in the Euro area, the average is 19.1%.

Composition of assets held in the EU (%)

Furthermore, taking a closer look at the composition of these assets paints an even bleaker picture. Out of the aforementioned 3.5% of financial assets that Croatians hold, 68% are held in the form of deposits, 8.3% are held in the form of life insurance or voluntary pension funds, while only 4.5% are held in the form of stocks. In Slovenia, the number of stocks held is 5%, while for the Euro area, it’s 8%. This would mean that in Croatia, only app. 0.16% of all assets held are stocks, a truly tiny number.

Breakdown of financial assets by asset type in the EU (%)

These are some of the main problems facing the Croatian equity market, and taking them all into account, one could say that the situation is pretty discouraging. However, there are various solutions that could be implemented to mitigate or even solve these issues. Achieving this will require effort and participation from all market participants, starting from the government, investors, regulators, the stock exchange, and of course, ending with the companies themselves.

Mihael Antolić
Category : Blog

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