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What does the rise in interest rates bring to businesses and households?

of Leonida Stergiou

The doubling of the key interest rate of the ECB than expected changes the data and the calculations to date. The analyzes concluded that significant effects on the real economy and the macroeconomic environment would be felt with an interest rate increase of more than 50 basis points.

Implications

The most important effects recorded by analyzes of banks and the Bank of Greece are the following:

An increase in interest rates on loans, even those with a floating interest rate that does not take into account the negative value of the euribor, as it is already positive for durations of 3 months. This mainly concerns business and consumer and variable rate mortgages.

Difficulty in raising capital from the markets for businesses.

Pressures on bond and stock prices.

Start of rising interest rates on consumer loans.

Possible, but gradual increase in the lending margin, due to an increase in the credit risk (profile) of the borrower (from the rise in borrowing costs, inflation, etc.

Increase in interest income for banks by around 250-300 million euros (annual basis) mainly on the loan side.

Almost zero increase in deposit rates as this comes with a rise in ECB interest rates above 0.5%.

Significant increase in fixed rates on new mortgages especially from 2023, with floating rates moving 2.5 points lower due to competition.

A slowdown in credit growth due to an increase in borrowing costs and especially if the real lending rate rises (nominal – inflation). In general, inflation boosts credit expansion as long as the real lending rate is negative or small.

Risk of an increase in bad loans, due to an increase in loan servicing costs.

Effects on the real estate market from a decrease in demand for housing loans and an increase in bad loans. The counterargument here is that inflation can turn real estate into a shelter and protection against income decline from rising prices.

Decrease in the competitiveness of the Greek economy, with negative effects on exports and the balance of payments if the exchange rate of the euro increases. On the other hand, imported inflationary pressures are decreasing.

The rise in the exchange rate of the euro increases the profits of funds already invested in Greek assets (shares, bonds, real estate, etc.) which may lead to the vesting of profits.

A 1 percentage point increase in the real interest rate leads to a 0.5% decrease in GDP

The slowdown in the economy from the rise in interest rates is due to a decrease in economic activity (fall in investment, higher cost of financing), which gives way to an increase in saving.

In addition, it causes a drop in values ​​(shares, bonds, real estate, etc.). This is related to the theory of the eternal value of money, i.e. better 5 euros today than 6 euros tomorrow. The present value decreases as the discount rate increases.

Rising interest rates create a lower net present value and for this reason stocks, bonds, etc. fall and the propensity to save increases. In real estate, this relationship is not so faithful, as other reasons intervene, such as demographic and cultural ones.

This is why real estate prices have been seen to rise and rise in times of high interest rates, but also fall significantly in times of low interest rates (usually associated with recessions, as in the recent financial crisis).

A rise in the real growth rate of 1 percentage point reduces the unemployment rate by 0.5 of a point in the same year and by 1.4 points the following year.

But they have shown that a 1 unit increase in unemployment is associated with a 3% drop in GDP. At the same time, a 1-point drop in unemployment is associated with a 0.2-point increase in inflation, as the Ocun and Philips models show.

How the ECB decision works

The decision to increase the ECB’s key interest rates by 50 basis points, instead of 25 basis points, as previously announced, caused the following changes:

First, the key ECB deposit rate from -0.50% was increased to 0%.

Second, the interest rate on the ECB’s main refinancing facility was raised to 0.5% from 0% previously.

Third, the ECB’s marginal lending facility rate increased from 0.25% to 0.75%.

Excess liquidity

These changes directly affect the behavior of the excess liquidity that had been created in the markets by the ECB’s support measures during the pandemic.

Zero and negative interest rates for 11 years and massive liquidity with the pandemic changed the compass that short-term and long-term interest rates (bonds) followed.

Before the multi-year period of negative interest rates and liquidity injections that followed the pandemic, short-term interest rates followed the ECB’s key refinancing rates.

Then they changed direction and followed the key intervention rate (deposit rate) which fell to -0.5% (today at 0%). Short-term funding costs, CDS and inflation swaps mainly reflect changes in bond yield curves (long-term interest rates).

There, a 1-1.5 point rise in the various durations had already been priced in, just from the first signs of persistent inflation.

Short term interest rates

Short-term interest rates are still moving at negative levels – despite their significant rise – due to expectations for a rise in the ECB’s key interest rate.

However, the shorter the interest rate, eg 1 month Euribor, the smaller the changes it showed until recently and remained negative close to -0.5%. The main reason was the amount of liquidity in the short-term durations, which, according to the data so far, would have required about a year to be absorbed.

On the contrary, as we move to longer durations, for example the 3-month euribor, greater upward movements are observed, with a tendency now to return to its compass, i.e. to the ECB’s base interest rate which is 0%.

euribor
Infogram

Euribor 1 month

Indeed, the 1-month euribor in June, when the ECB rate hike of 0.25 of a point was announced, was at -0.541%, i.e. quite close to the levels that have been moving all these years with negative ECB interest rates.

However, during July and as the indications of persistent inflationary pressures increased, as well as the voices of ECB members for a possible increase in interest rates by 0.5 of a point, the 1-month euribor increased to levels of -0.35% and yesterday at -0.259%. That is, it tends to reach the key ECB interest rate of 0%.

What does the rise in interest rates bring to businesses and households?
Black line: 3-month Euribor
Blue line: Euribor 1 month

3 month Euribor

The 3-month euribor is moving upwards more aggressively, leaving negative levels on July 13. Yesterday it had climbed to +0.125%, with a tendency to reach the refinancing rate which rose to 0.5%

These moves primarily affect floating rate loans, which make up 90-95% of loans in the Greek market. Almost all consumer and business loans are floating rate, based on the 3-month euribor.

Also, the majority of existing mortgage loans are floating rate, based on the 3-month euribor, while few are linked to the 1-month euribor.

The trend for fixed-rate mortgages that reached new disbursements to represent as much as 55% does not overturn the average in the existing housing stock, as new loans are much smaller than old ones. Suffice it to say that total disbursements in 2021 corresponded to new mortgages 1 month before the 2008 crisis.

The transition of the 3-month euribor to positive levels affects a significant portion of loans, whose final interest rate did not take negative values ​​into account. So, until the euribor reached 0%, the borrower only paid the margin.

The same for those with 1 month euribor, although there are more – mainly mortgages – on the market that were disbursed earlier and take into account negative base rate values. That is, the final interest rate results from the sum of the euribor and the margin.

Loans

In fixed-rate loans, their pricing is primarily influenced by bond yield curves, as swaps are used to lock in interest rates over long maturities.

The rise in interest rates does not affect banks that have granted fixed rates, as they have been “locked in” to a fixed cost. However, new loans with a fixed rate will show an increase.

According to banking executives, the competition is keeping them relatively low, but they will soon increase in order to be significantly different from floating rate mortgages to be competitive and attractive solutions.

Bank executives estimate that the differences between fixed and floating mortgage rates will appear after September.

Their difference will be around 2.5 basis points. Based on the calculations until yesterday, in 2023 they calculated that the mortgages with variable interest rates would reach 4-4.5% and the fixed ones at 6.5-7%.

However, banks and the Bank of Greece in its latest report states that the rise in interest rates on loans will probably start with consumer credit due to the higher credit risk. Besides, there is a great demand for these loans, as shown by the figures for the first half of the year.

However, the rise in interest rates increases credit risk in general, so it is possible that there may be upward adjustments to the spreads on floating interest rates as well. As the cost of borrowing increases, so does the risk of default, especially in an environment of inflation and declining disposable income.

In any case, the adjustment of interest rates and margins will depend on competition and demand. For example, already after the big rise in bond yields and the rise in euribor, interest rates on retail and business credit did not change significantly. In fact, some banks showed margin reduction in order to gain market shares before the interest rate hike.

Deposits

In deposits, banks estimate that the rise in interest rates will come, or at least be felt, when the ECB raises its key interest rate above 0.5%. From 0% (today) to 0.5% any increases are marginal or zero as banks try to limit interest rates on loans.

Beyond that, history shows that less than half of the ECB’s increase each time is spent on deposits. Of course, the final interest rates are also determined by other parameters, such as liquidity, loan financing costs, credit expansion, provisions, etc.

According to the models the banks have run, the 0.5 basis point increase in interest rates decided by the ECB will increase interest income by almost 250 million euros for the four systemic banks.

On the other hand, a 20% reduction in borrowers’ disposable income from inflation can cause 500 million euros in bad loans. Already, banks estimate that disposable income has fallen by 8%.

At the same time, there is the risk of losses from falling bond valuations. Already, the valuations in the banks’ portfolios based on the latest data from the Bank of Greece show a drop of around 3 billion, but this does not mean that it is real and that it will burden their profits, because intermediate transactions take place.

Source: Capital

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