Will the CB follow the ECB upwards?
Borrowing costs for the many Cypriots who have taken out euro loans will rise this week after the expected increase in European Central Bank (ECB) interest rates on Thursday August 3.
The ECB is expected to increase the main refinancing operations rate by 25 basis points to 3.00% from 2.75%. The last time the rate was 3% or above was early December 2001.
For euro borrowers in Cyprus, this is the fourth time within the past 12 months that they have seen the cost of borrowing rise.
The ECB began raising rates in December 2005 and has so far raised rates by 75 basis points. This week’s increase will bring the cumulative hike to 1%.
Despite the steady rise in costs, Cypriots have borrowed euros like there is no tomorrow. FX lending to residents reached CYP 1,62 bln in June, a rise of 58% on June 2005, according to Central Bank data.
Cyprus pound borrowers, on the other hand, have seen their borrowing costs remain steady for over a year. The last time the Central Bank touched rates was on June 9, 2005, when it cut rates by 50 basis points.
The Cyprus Lombard rate (marginal lending rate) is now at 4.25%, 50 basis points above the equivalent marginal lending rate of the ECB at 3.75%.
According to our information, around 65% of the CYP 1.62 bln in resident foreign borrowing is in euros.
A 0.25% increase in euro rates will therefore mean an immediate jump of just over CYP 2.6 mln in borrowing costs, according to Financial Mirror calculations.
Another increase in costs in late 2007
Euro borrowers are also facing another potential increase in costs in late 2007.
This is likely to be the time when the Cyprus pound’s final exchange rate to the euro is fixed.
At the moment, the pound is about 1.7% stronger than its central parity rate.
If the Cyprus pound joins at its central parity rate, euro borrowers will see the value of their loans increase overnight by 1.7%.
Borrowing costs would therefore rise by a further CYP 18 mln in late 2007.
Will the Central Bank of Cyprus follow suit?
The big question is whether the Central Bank of Cyprus follows the ECB at its next meeting on September 1 and hikes interest rates too.
It might want to do this for two reasons. First, in order to contain inflation, which has been on the rise.
Second, to keep some “room for manoeuvre” to cut rates between now and the fixing of exchange rates next year. If the Central Bank does not raise rates with the ECB now, it will have only 25 basis points left to play with.
Those who believe a rate-rise is imminent point to short-term interest rates, which have been rising. However, there are also arguments the other way. For example, those who think that the Central Bank will not raise rates point to the long-term yield.
The long-term yield is one of the Maastricht criteria, although it is a bit difficult to predict what exactly the benchmark interest rate will be when the assessment is made next year, because it depends on the inflation rates of 25 member states.
However, the German ten-year bund is used as the proxy benchmark.
Although yields on Cyprus’ ten-year government bonds rose from 4.03% on May 30 to 4.28% on July 7, they are still well within the 2% comfort zone for meeting the relevant Maastricht criterion. German bunds were 3.98% last week.
Only if that spread began to widen sharply would the Central Bank really need to take action in order to ensure that it met the interest-rate criterion.
Whatever the Central Bank does, there is a lot of money at stake. If the Central Bank of Cyprus follows the ECB and pushes rates upwards, the borrowing costs for residents will rise by a total of 240 mln.
