What chaos can currency risk cause has been brutally felt by borrowers in Swiss francs. And that risk, at least in terms of the relationship between the kuna and the euro, disappears with entry into the Eurozone. There is still a year to go (assuming no sudden barriers emerge) and until then we remain in the ERMII exchange rate mechanism. In it, the kuna can still fluctuate against the euro, which means that currency risk as a generator of overall credit risk exists until the introduction of the euro as Croatia’s currency. This is precisely why the former, late governor of the Croatian National Bank (HNB), Željko Rohatinski, tried to make kuna loans and kuna savings more attractive even before the last financial crisis.
The crisis thwarted that attempt, but as interest rates on kunas and euros began to equalize over time, there has indeed been a trend of increasing kuna loans in the total number of newly approved loans in recent years – partly due to public sensitization after the Franak case, and largely due to the decreasing interest rates for kuna loans (which have always been more expensive) finally approaching those in euros.
The HNB has already reported in detail on the conversion of kuna loans to euro loans; everything will happen automatically, at no cost to bank clients. It is not even a question of whether it will be more favorable or not, precisely because the interest rates have equalized quite a bit, so the differences in monthly obligations for all who have kuna loans should be minimal. However, interest rates are precisely the risk that remains even after conversion. Especially since we are entering a period of expected interest rate growth, primarily due to inflation, which does not seem to be of a transient nature. The HNB states that when it comes to interest rates on loans, they depend on a number of factors, among which the most important are the borrower’s risk, the risk of the country in which the borrower and the bank operate, regulatory costs, the cost of funding sources, and the margin that the bank determines and incorporates into the interest rate.
It depends on inflation
– Entry into the euro area will act towards reducing interest rates on loans, especially due to the reduction of borrower risk. Namely, most bank borrowers (including the state) are heavily exposed to exchange rate risk, as they earn income in kunas, while their debt is in euros or has a currency clause in euros. With the introduction of the euro, these borrowers will have income and debt in the same currency. Additionally, with Croatia’s entry into the euro area, regulatory costs will also decrease; for example, the reserve requirement rate for banks will significantly decrease, which also allows for a drop in interest rates. However, interest rates in the domestic market will also depend on the future movement of funding source costs and the risk of the state. Thus, the costs of funding sources will depend on the interest rate policy of the European Central Bank, while the state’s risk will depend on fiscal policy management and the overall performance of the economy. The process of building a European banking union could negatively affect bank margins, the HNB says.
It is crucial, therefore, to assess how interest rates will move in the times after Croatia’s entry into the Eurozone. And this will primarily depend on the assessment of inflation trends. Central banks of large developed countries, which are somewhat less exposed to inflationary pressures, have so far been quite restrained in adjusting monetary policy due to the assessment that these pressures are temporary and will gradually ease during 2022, according to the HNB. However, as they expect medium-term stabilization of inflation around targeted levels, they have begun to normalize monetary policy by announcing or reducing pandemic asset purchase programs, which precedes the start of raising reference interest rates.
Among large developed countries, the US FED is leading in this regard, which, according to the latest announcements, is expected to suspend its asset purchase program by mid-2022, after which markets expect a gradual increase in reference interest rates from the current 0.25 percent to 1.05 percent by the end of 2023. The ECB also expects relatively quick easing of inflationary pressures, which are somewhat weaker in the euro area than in the US, so it does not see the need for a significant acceleration of the monetary policy normalization process. In September, the ECB slightly reduced the scale of the pandemic asset purchase program (Pandemic Emergency Purchase Programme), but reiterated its readiness to keep key interest rates at exceptionally low levels until it assesses that core inflation has sufficiently progressed towards the targeted level of 2 percent in the medium term. Under such conditions, markets do not expect an increase in ECB interest rates before the end of 2023, and even then, according to market expectations, it could amount to only 0.05 percentage points, the HNB concludes.
No exchange rate risk
However, while short-term market interest rates are directly influenced by current monetary policy, long-term rates depend more on macroeconomic prospects and expected future moves by central banks, as well as on risk perception. For these reasons, yields on 10-year government bonds in the US have increased by about 60 basis points over the past year. A significantly smaller increase is recorded in the European market, but it also indicates a rise in inflation expectations. Markets expect that yields on bonds will continue to rise, somewhat more pronounced in the US than in the euro area, but they could remain below the levels they were at before the global financial crisis, especially at the beginning of the century.
