Economists are confident the island’s economy and banking system will not be impacted by a rise in interest rates in the Eurozone, despite warnings by the European Central Bank.
In its latest Financial Stability Report, the ECB issued a warning to banking systems in the European south that they will come under stress as hiking rates would likely increase their exposure to non-performing debt.
“Banks in Italy, Portugal, Greece and Cyprus could suffer some of the biggest increases in non-performing loans,” said the ECB.
Central banks have been raising interest rates in tandem; the European Central Bank has tightened by two percentage points to 2% between July and November, while it is set to review interest rates mid-December, expected to raise them higher.
The ECB also said: “The simulated impact on banks’ asset quality from the end of 2022 is material, albeit from historically low non-performing loan (NPL) levels, with a downside estimate of the NPL ratio increasing by 80 basis points.”
According to the ECB, the problem lies almost entirely with lower-income households, as a 10% rise in the basic cost of living for them would lead to a 20% reduction in spending power, compared to just a 5% reduction among middle-income households.
The European Commission’s autumn forecast raised their yearly inflation rate projection to 9.3% in the EU and 8.5% in the euro area.
Inflation is expected to decline in 2023, but not considerably, more toward 7% in the EU and 6% in the euro area.
With inflation rising to double-digit territory, households are burning through their savings with little respite as income growth trails far behind, especially for the poorest, disproportionately hit by surging food and fuel costs.
According to ECB calculations, the lowest-income families hold just 13% of eurozone household bank debt, with 70% held by higher-income households, which are not seen suffering materially.
In comments to the Financial Mirror, Ioannis Tirkides, Chief Economist at the Bank of Cyprus, argued that “fiscal policies, including interest rates, combined with market uncertainties harbour the risk of financial instability for some advanced countries under certain conditions.
“Cyprus, however, is not one of them”.
“How far can central banks go in their tightening cycles?
“The simple answer is they will go as far as necessary to bring inflation under control.
“This can mean between 5 and 6% in the case of the federal reserve in the United States, and between 2.5 and 3% in the case of the ECB”.
As Tirkides explained, this could mean that prime lending and mortgages in Europe, including Cyprus, might reach 5% to 6%.
Likewise, yields on the Cyprus government’s long bonds can reach 4.5% by the end of next year, maybe a little higher.
“Can these developments lead to financial distress?
“The risks of financial instability are more acute in emerging markets because of substantial dollar-denominated liabilities, and less so in the advanced countries, but not entirely unlikely for specific countries”.
He said that widening interest rate spreads too much could cause problems for highly indebted countries.
“For this reason, the ECB introduced a new tool in July, the Transmission Protection Instrument, which allows it to purchase bonds of member states and thus lower the respective interest rate spreads, provided their debt is sustainable.”
Tirkides argued that with probably the exception of Italy, which has the second highest debt after Greece, the other EU countries are well positioned to ride out the global economic slowdown without going into a broader systemic crisis.
Italy has the second highest public debt in the euro area after Greece, but in contrast to Greece, it has the highest debt interest cost in relation to GDP, nearly 4% on average.
“The situation in Cyprus does not pose a similar risk, neither in terms of its public debt nor its private debt.
“Cyprus’ consolidated public debt is estimated at 90% of GDP in 2022 and 84% of GDP in 2023”.
He argued that fiscal risk for Cyprus is low as interest costs on its existing debt are relatively low at about 1.5% of GDP.
“Debt maturity is also long, near eight years.
“Consequently, the interest cost on the debt will rise slowly if the current situation of high inflation and higher interest rates persists, and it will take a long time before it threatens debt sustainability.
“Similarly, in the banking sector, private debt does not pose an alarming threat at the moment for several good reasons.”
Tirkides said private indebtedness had fallen steeply since the banking crisis, and interest costs are considerably lower for companies in absolute and relative terms, while they have a better funding structure of equity-to-debt today than in the past.
At the same time, banks are in a significantly better position to manage such problems should they occur.
Total private debt at the end of September, measured as loans to residents excluding the government, was €22.8 bln, of which €2.8 bln were non-performing exposures against which provisions amounted to €1.5 bln.
Thus, net private debt is €21.3 bln or about 80% of GDP, compared with 270% of GDP in 2012.
“Against this balance sheet, the banking sector is very well capitalised.”