Filenews 1 May 2022 - by Theano Thiopoulou
After a decade, the ECB appears ready for the first interest rate hike early in the summer, and this opens up the debate as to what the new decision will signal, what are the fears about private debt and especially about low-income households, which are mostly heavily indebted. This decision, when formally taken, is expected to affect the state's borrowing, in terms of the cost of raising capital and refinancing debt. Eyes are now on the ECB's monetary policy governing council meeting in early June. Most predict that the ECB will decide to raise the interest rate and many analysts predict that the year will end with at least three consecutive increases in key interest rates.
For the European Central Bank, this is one of the most crucial periods in its recent history. It is no coincidence that the leaks of the board of directors recorded in the foreign news agencies, depict the division between the so-called "hawks", who demand an immediate reduction in the expansionist policy and the so-called "pigeons", who fear that such a move will affect European development. The hawks have long criticized the ECB for underestimating inflation, which reached an average of 7.5% in the Eurozone in March.
Policy mix, not just growth
"F" records the views of Stelios Platis, economist, non-executive chairman of MAP S.Platis Group and economist Christakis Patsalides, on what the expected change of monetary policy by the ECB means for Cyprus.
As a general assessment, with the question of what impact the ECB's intention to raise lending rates will have on the European economy and how much the ECB's intention to raise lending rates will affect Cyprus in particular, "the ECB is probably one of the last main central banks in the West to intervene with an interest rate hike. At least on the basis of intentions, as it now appears. And this relates to the predicament in which the ECB finds itself today. European economies are particularly affected as a result of the ongoing Russian invasion and also of the sanctions that the EU itself has imposed. This concerns both inflation, which is already three times the ECB's target, and significant recessionary pressures, given that the EU imports around 60% of its energy needs. But also through the supply shock of critical raw materials for European industry. In the extreme scenario, Eurozone economies could have to face a stagflation shock. And the ECB's role is very important in the process of avoiding such a scenario. I believe that we will see a policy mix, rather than a simple increase in interest rates, with an expansionary fiscal policy consisting of both support and growth measures. Therefore, the effects of the increase in interest rates cannot be analysed on their own at Union level. In Cyprus, of course, we have not yet seen any substantial support measures, but I believe that they are being imposed and that they should be expected, as part of a pan-European strategy. Especially towards the low and middle income strata. But also in the direction of supporting development."
Normalize expectations
For his part, Mr. Patsalidis points out that "the ECB has announced that before any increase in its key interest rates, it intends to complete its asset purchase programme in the third quarter of the year. International markets, however, anticipate a rise in interest rates more quickly, given the significant increase in inflation occurring across the eurozone, due to increases in energy and commodity prices. When and when the ECB raises interest rates, and if it is judged that the rise in interest rates is in line with the stated objective of stabilising inflation at 2% over the medium term, then such an increase will lead to the normalization of expectations and the move away from negative/zero interest rates that are not normal and have other side effects in all euro area countries; including Cyprus".
Problem with the over-indebted
But what about public and private debt in the event that the ECB starts to raise the cost of money? Mr. Platis points out that "unfortunately, non-performing loans remain one of the main problems of our economy. At the same time, private borrowing by Cypriot households remains among the highest in the EU. Undeniably, raising key interest rates raises the cost of money. This in turn will also increase the cost of servicing loans. Disproportionately affecting the households with the lowest incomes, most of whom are heavily indebted. Added to this is the fact that strong inflationary pressures are expected to make it more difficult for households with the lowest, low and even middle income earners. Since they have to spend much more on electricity, fuel, heating and food, in relation to their incomes, negatively affecting their ability to service their existing borrowing.
At the level of public debt", adds Mr. Platis, "we must note that the risk of bankruptcy has risen internationally. Especially in cases of greater relative risk. That is, the developing countries and countries of the periphery, such as Cyprus. This raises the risk premium and usually leads to an increase in the cost of borrowing in the next phase of raising money, through government bonds. This means that the arrears for 2022 and 2023 (around €3.5 billion) may be refinanced at a higher cost (although it appears that the amount of cash will cover the financing needs at least for 2022)."
Blocking factor for investments
To what extent could the increase in the cost of money affect growth and investment? Mr. Platis replies that "in general, the increase in the cost of money acts as a deterrent to development initiatives and investments. Since in most cases it raises the required amount in return from an investment - a higher cost of money requires greater returns. And that limits the range of investments. At the moment, however, we are also experiencing a shock to the supply of important raw materials, which makes development and investment initiatives even more difficult. I repeat, however, that my assessment is in the direction of an economic policy mix, rather than a simple increase in interest rates. That is, state support and investments, supported by the state, with potentially increased budget deficits. In this case, we may see less, under the circumstances, impact on development. Of course, this policy mix needs careful moves and is easy to lead in the opposite direction."
Mr. Patsalidis explains for the same question (influencing growth) that "the goal of increasing the cost of money is to slow down economic activity and growth - less borrowing/investment, more savings - in order to avoid the risk of overheating, since high inflation erodes long-term growth. The risk of a restrictive policy to be pursued is an excessive slowdown in economic activity, without achieving the objective of reducing inflation. In extreme cases, but still observed today (such as shortages of materials and raw materials), the risk of stagnant inflation is not entirely outside the picture. But if we accept the ECB's estimates that price escalation due to shortages is temporary, then the possibility of stagnant inflation is completely removed. In such a case, we are led to lower growth, without inflationary pressures. Cyprus, as a small and open economy, is expected to be affected. On the other hand, there are so many other dynamics that affect the economy, both positively (e.g. the recovery & resilience programme) and negatively (e.g. sanctions against Russia). It is the sum total of the indirect effects of the developments in the international economy and the most direct ones that concern specifically our own economy, that will ultimately determine the course of growth of the economy".
Delay in development
On the question of how long it takes for the mechanism to increase interest rates to work in the direction of lowering prices and prove to be a weapon against inflation, Mr. Patsalidis says that "history has shown that increased interest rates lead to lower inflation, provided that the rest of the data is stable. Today, the debate is taking place whether central banks have delayed pushing interest rates upwards and whether inflation has slipped away. In such a case, the duration of the higher interest rate regime should be made longer in order to achieve the objective, causing a delay in the growth of the economy.
On its own," adds Mr. Platis, "the ECB cannot control and direct inflation to the desired target. It is important that, like all macroeconomic policies, and in particular fiscal policies, they are aligned towards achieving this objective. The ECB is targeting the euro area average rather than a country-specific index. Today, Lithuania and Estonia record inflation of 15%, with the euro area average of 7.5%. Cyprus is at 6.2%. It is therefore important that Cyprus continues its effort for fiscal consolidation, so that it can enjoy interest rates that are in line with its own economy in the medium term.
Platis: Things are quite more complicated
"Unfortunately, things are now considerably more complicated than an ordinary effect of a (under normal circumstances) relationship of interest rates and a reduction in inflation," Stelios Platis notes. The prices of energy, commodities and raw materials have already soared. And this, at a time when a major problem is being maintained in the supply chain, with a shock of supply of important raw materials, but also energy. With this in mind, the nature and type of inflation today, as well as the related structural causes that have led and are holding prices upwards, seem to point to the maintenance of strong inflationary pressures for the remainder of 2022, despite the rise in interest rates. Beyond that, the policy mix, the fiscal manoeuvres of the major EU economies and the further actions of the ECB will, I believe, be under constant monitoring, review and readjustment. The bet is to avoid stagflation scenarios," he concludes.
Patsalides: Cyprus will be most affected
Mr. Patsalidis answers the question "what will happen to public and private debt in the event that the ECB increases the cost of money?" that "a continuous increase in interest rates will tend to burden the cost of servicing public and private debt. In the case of loans at variable interest rates, the burden will be more direct, while debt invoiced at fixed interest rates (usually government bonds) will only be affected during refinancing. Cyprus is more affected than the Eurozone average. First, solvency ratios are lower and therefore we bear higher borrowing costs, reflecting the country's higher credit risk. In general, the higher the interest rates are and the higher the credit risk margin (which is part of the interest rate). Secondly, the business sector in Cyprus relies more on borrowing, compared to the average business in the Eurozone, and therefore an increase in interest rates will disproportionately burden Cypriot business.
