Interest Rates in Times of Inflation: Short-Term Likely Up

Despite the announcement from the European Central Bank (ECB) regarding the gradual increase of reference interest rates, which will eventually be reflected in our loans, borrowers who have taken out loans with variable interest rates occasionally receive notifications about – a decrease in interest rates! The latest to do so was OTP banka, which reduced interest rates on loans, albeit by a symbolic 0.01 percentage points for loans with a clause in euros, while loans in kuna will be lower by 0.02 percentage points.

At the same time, the Croatian National Bank (HNB), due to the official confirmation of accession to the eurozone, has made decisions regarding the gradual reduction or elimination of mandatory reserves and the minimum required foreign currency claims for banks, which will free up more than 34 billion kuna and 5 billion euros in costs by the end of the year. This certainly calls for a reduction, not an increase in interest rates, or at least takes away the banks’ alibi for raising rates because Europe/ECB is doing so. Governor Boris Vujčić clearly stated that with these moves, banks really have no reason to raise interest rates, but practice teaches us that logic and profit are generally not on the same wavelength.

How do banks think? Except for Erste banka, which is generally very cooperative with journalists, none responded; they passed the baton to HUB.

– For now, we can conclude that there is still no visible pressure for an increase in interest rates; on the contrary, there is still a downward trend in some types of loans. As with any product, output prices (in this case, interest rates on loans) depend most on input costs (interest rates that banks pay on deposits and other sources of funds), operating costs, and regulation. In the upcoming period, Croatia is joining the euro area, which will reduce regulatory costs and the state risk premium and strengthen competition. The liquidity of the banking system is already high, and with the abolition of the obligation to hold minimum required foreign currency claims, additional liquidity will also be released. All these elements indicate that monetary and financial conditions in Croatia will tighten more slowly compared to the current eurozone members – they state from HUB.

At Erste banka, they say that the expected reduction in regulatory costs arising from Croatia’s entry into the eurozone is certainly one of the components that will have a positive impact on the level of interest rates and generally on lending conditions in Croatia in the medium term.

– Along with other benefits of integration into the monetary union, such as the practical elimination of currency risk and contributing to the reduction of the risk premium, and considering the fact that the banking system in Croatia has already been highly liquid for some time, the expected rise in interest rates in Croatia, especially in relation to some other European countries, should certainly be mitigated to some extent. However, it should be emphasized that, in the short term, the level of interest rates in the upcoming period will predominantly depend on the moves of monetary policy makers in the segment of raising reference interest rates, primarily the European Central Bank, as a response to the current environment of high inflation and the accompanying uncertainties related to the war conflict in Ukraine – they state from Erste.

Thus, in the short term, interest rates will likely go up, which is now partially mitigated by the fact that those linked to the national reference rate (NRS) are mainly falling (interest rates linked to EURIBOR ‘are not that lucky’). Erste banka explains what is happening.

– When discussing existing loans with variable interest rates, it is important to note that the change is not based on an increase in the interest margin, but on a change in the variable part of the interest rate, i.e., the part of the interest rate that is linked to reference rates (EURIBOR, NRS). It is important to emphasize that the transmission of the rise in reference interest rates is faster for clients with loans linked to EURIBOR, while on the other hand, the widespread use of NRS in forming interest rates reduces exposure to interest rate risk, meaning that the increase in repayment burden will be gradual and with a time lag in accordance with the nature of determining the NRS rate – they reassuringly state from Erste, adding that the adjustment of variable interest rates to movements in reference interest rates occurs every 6 or 12 months, in accordance with the agreed parameters of each loan.

Thus, for some of their clients, users of loans with variable interest rates, whose interest rate is adjusted twice a year, on July 1 and January 1 of each year, during the last adjustment, the variable part of the interest rate that depends on the movement of the six-month EURIBOR for euro loans, or the six-month NRS2 for kuna loans, was changed. These changes affected about 2,200 clients/loan parties out of a total of about 45,000 loan parties of citizens with variable interest rates, which are in the bank’s portfolio.

– It is important to note that the increase in the interest rate is solely caused by the rise in the reference parameter, i.e., that the fixed part of the interest rate (margin) has not been increased – they conclude at the bank.

From HUB, they state that an additional safeguard is the large number of loans contracted with fixed interest rates.

– At the sector level, we can observe a multi-year trend of declining shares of loans with variable interest rates, which ultimately affects the greater resilience of households to interest rate risk. According to the latest available data from HNB, 62 percent of consumers have a fixed or combined interest rate, while 38 percent have a variable one.

The national reference rate (NRS) is the most prevalent reference parameter for linking interest rates on household loans (67 percent), while 18 percent of loans are linked to EURIBOR. The European Central Bank has started a restrictive monetary policy, and the first increase in key interest rates is expected soon, which will eventually reflect on interest rates in Croatia. Central banks, including the ECB, maintain price stability and influence inflation by setting interest rates. When a central bank wants to prevent excessive inflation, it usually raises interest rates to make borrowing more expensive and saving more attractive.

As with any product, the output price depends most on input costs (interest rates that banks pay on deposits and other sources of funds), operating costs, and regulation. There is strong market competitiveness in banking in Croatia, and each bank has its own business policy and interest rate strategy. However, after the positive decision of the EU Council, Croatia will join the euro area on January 1, 2023, which will reduce regulatory costs and the state risk premium and strengthen competition. This will affect the slower increase in interest rates compared to current eurozone members.

The expected tightening of monetary policy in the euro area will act in the direction of increasing interest rates, which has already led to an increase in interest rates on government bonds in many countries, including Croatia – they say in the banking association.

So, at what level can we expect future interest rates, primarily those on loans? It is clear that Europe, although significantly slower than, for example, the USA, has chosen a likely recession (caused by rising interest rates) as a tool in the fight against inflation. The ECB hesitated for a reason, as the European economy is still in the process of recovering from the economic shocks caused by the pandemic. Additionally, the economic consequences of the war in Ukraine are being carefully analyzed, especially due to the high dependence on Russian energy sources. The direction of monetary policy change and interest rate movements is known, but it is currently difficult to predict the speed and overall duration of the interest rate hike cycle.

– It is important to emphasize that the introduction of the euro has long-term ensured more favorable financing conditions compared to those that would prevail if the kuna remained the official currency – they are categorical at HUB.

At Erste, they add that protection against rising interest rates is still possible – by contracting a fixed rate.

– In order to protect against a potential rise in the reference interest rate in the future, Erste banka has been offering the possibility of changing the type of interest rate from variable to fixed or combined for many years. This is a simple procedure that involves signing an annex to the contract and its solemnization. Aside from the costs of a public notary, the change in the interest rate does not incur additional costs for the client – they explain.

For ‘just in case’, check if your bank offers such a thing.

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photo HNB

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photo HNB

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