Low credit interest rates unlikely to last long

The global financial crisis with its adverse effects on real economic growth has occupied an almost permanent place in media coverage for a couple of years now. The crisis has affected lending and interest rates in Latvia as well. New borrowers have to reckon with substantially higher mark-ups above the money market interest rates than before. As to the loans in lats, the variable component of interest rates has become more unstable and less predictable. However, not all trends of the interest rate dynamics should be marked with a negative sign. The borrowers in euro stand in stable positions, as the variable component of interest rates on loans in euro has been progressively down since late 2008, gradually hitting a record low. Of late, RIGIBOR interest rates have come close to those of EURIBOR. Is such interest rate dynamics going to persist also in the future? Can the euro interest rates be sustained at their lows? What can most affect the lats interest rates? An attempt to elucidate these problems is made hereafter.

The EURIBOR future dynamics is a much speculated topic. Obviously, the situation is going to change sooner or later, with EURIBOR posting a pickup. To a large extent, EURIBOR interest rates depend on the key interest rate set by the European Central Bank (ECB) for the euro. By setting euro rates, the ECB pursues the objective to maintain price stability, i.e. inflation at or below 2% in the euro area. When inflation is high or likely to rise in the euro area, the ECB raises as a rule its key interest rate, in such a way subduing the lending and money stock growth. On the other hand, when inflation is low and its elevation is not expected in the near future, the ECB can afford leaving the euro key rate unchanged or even lower it. The relationship between the ECB rates and the economic growth in the euro area is similar: with the economic activity expanding, the rates are likely to go up, while with the economy withering, the ECB lowers its key rates or at least does not raise them.

Currently, the situation in the euro area economy is obscure. The German gross domestic product (GDP) has been sending positive signals as early as from the end of August; according to the estimates produced by the German central bank, GDP has been projected to grow by around 3% in 2010 overall. GDP in all other euro area countries, except Greece and Ireland, also recorded a quarter-on-quarter growth in the second quarter. Nevertheless, the outlook for the German economy in 2011 is less promising, with quite buoyant euro area development unlikely to re-occur in the third quarter. At this juncture, the euro area inflation is below the 2% margin. That makes analysts of major world banks assume that the euro key rates might go up in mid-2011, and they consider the scenario of a moderate rather than steep interest rate rise to be the most realistic.

However, EURIBOR rates can increase also in the event of the ECB leaving the euro key rate unchanged and the loans to the euro area banks contracting, compelling the banks to leave the crisis area and return to the former daily routine of interbank or mutual lending. During the crisis, in order to supply banks with the needed funds, the ECB had temporarily injected huge financial resources into the market, which made the price of money fall in the interbank market. In the middle of 2010 when the situation stabilised, the euro area banks resolved at their own initiative to minimise their resorting to the ECB funding, cutting their borrowing capacity by almost 250 billion euro. Within two weeks, EURIBOR rates edged up by 0.05-0.1 percentage point. If euro area banks regain strength and the ECB gradually withdraws its accommodative bank lending policies, EURIBOR rates might edge up. Confidence of euro area banks in the economic growth and financial stability in the euro area also plays an important part. For instance, market agents' concerns about Greece's sovereign debt financing ability caused an upswing in EURIBOR interest rates.

The lion's share of borrowing in Latvia is in euro most likely due to lower interest rates. Fixed-rate loans in lats are mainly taken for the purpose of buying consumer goods or as payment card credits. RIGIBOR or interest rate on loans in lats quoted in the interbank market tends to fluctuate substantially under the influence of market psychology, which in turn depends on economic policy decisions and public statements in Latvia. For instance, the hike in lats interest rates experienced at the beginning of 2007 can be explained by rumours and speculations about devaluation of the lats, which abated soon thereafter. The rates climbed also in September of 2008 due to the financial market turmoil in the US and later in Europe as well, to record aggravation in the concluding months of the year as an even stronger uncertainty shrouded Latvia's future. Ambiguity surrounding the budget-making process at the beginning of 2009 combined with the statements of some influential individuals about the lats in June made RIGIBOR rise above 20%. When it became clear that the Latvian government was going to proceed with budget consolidation measures, the interest rates hit historic lows. Hence lost credibility and high interest rates are the cost of uncertainty, this being a fundamental factor capable of substantial effects on payments for loans in lats (and not only) in the future.

As the lats is pegged to the euro, their respective rates should converge in a stable situation (the process is observed currently). Circumstances were similar after the pegging of the lats to the euro, when the interest rate spread of the two currencies narrowed and did not notably exceed 2 percentage points for a protracted period. Presumably, an eventual rise in the EURIBOR rates could have implications for the lats money market rates as well. The lats and the euro interest rates cannot be absolutely identical, for the factors affecting them, i.e. central bank key interest rates, resources at the disposal of the euro area and Latvian banks, changes in the available bank resources, risk perceptions regarding the euro area and Latvia (heightened risk perceptions translate into higher rates), are different.

If interest rates in the money market are going to rise, borrowers will face higher credit payments. However as noted before, the anticipated interest rate hikes are unlikely to be steep. Nevertheless in the context of interest rate elevations, those with a longer fixation period seem a more likely option than before. Presumably, many borrowers currently should think about putting aside funds saved on account of today's lower interest rates, so as to use them for growing payments later.

The article was published by Delfi on 28 September 2010.

APA: Mičūne, V. (2022, 26. may.). Low credit interest rates unlikely to last long. Taken from https://www.macroeconomics.lv/node/1836
MLA: Mičūne, Vija. "Low credit interest rates unlikely to last long" www.macroeconomics.lv. Tīmeklis. 26.05.2022. <https://www.macroeconomics.lv/node/1836>.

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