2022.07.22 17:00

How will ECB rate hike affect Lithuanian debtors and economy?

Jonas Deveikis, 2022.07.22 17:00

The European Central Bank (ECB) on Thursday raised its base rate by 0.5 percentage points for the first time in 11 years, more than forecast.

The ECB’s main reason for the hike is to put the brakes on unprecedented inflation, which reached 8.6 percent in June in the euro area and more than 20 percent in the Baltics.

Raising interest rates dampens economic growth. Businesses find it more expensive to borrow, which reduces investment, while people are encouraged to save by putting their money into deposits, thus increasing the demand for money and pushing prices down.

However, studies show that it takes two years for the negative effects of an interest rate increase to become apparent on the price level, so it is unrealistic to expect the ECB’s interest rate increase to lead to a rapid decline in prices.

An increase in the base rate also affects EURIBOR, which is the benchmark for many loans.

On 20 July, the 12-month EURIBOR reached 1.16 percent, the 6-month EURIBOR 0.63 percent, and the 3-month EURIBOR 0.12 percent.

Markets predict that the ECB will not stop there and will raise the base rate again by 0.25-0.5 percentage points in September and possibly by another 0.25 percentage points in winter.

The expectation is that the 6-month EURIBOR could rise to 1.4 percent as early as the end of the year, and to 1.7 percent next year. The base rate is not expected to be cut any time soon, so EURIBOR will rise over the next 10 years to 2.6 percent.

For most loans, this could mean rising repayments. How much the loan premium will change will depend on the size of the loan. For example, when EURIBOR reaches 1.5 percent later this year, monthly repayments on a 20-year mortgage could increase from 253 to 290 euros for a 50,000 euros loan, from 405 to 464 euros for an 80,000 euros loan, and from 759 to 870 euros for a 150,000 euros loan.

However, the Bank of Lithuania estimates that the average balance of a housing loan in Lithuania is currently around 50,000 euros, and the average housing loan payment is 230 euros, so the interest rate increase will not have a significant negative impact on most housing loan holders.

The Lithuanian government will also face an additional burden due to rising borrowing costs. At the end of 2021, public debt amounted to 24.5 billion euros or 44.3 percent of Lithuania’s GDP. Debt servicing costs totalled 346.5 million euros.

This year, debt servicing management costs are estimated to be 290.5 million euros. Only part of the public debt is refinanced each year, so the effect of interest rate increases will be moderate. Moreover, the portion of the debt with a variable interest rate is only around 1 percent of the total, according to the Finance Ministry.

Although the ECB has increased the base rate more than previously expected (0.5 points instead of 0.25), this is still a relatively small hike compared to some of the other central banks.

In the US, the base rate is already at 1.75 percent and could rise to almost 4 percent by the end of the year, in the UK at 1.25 percent, in Poland at 6 percent, in the Czech Republic at 7 percent, and in Hungary 9.75 percent.

The ECB has long delayed raising the base rate because much of the inflation has been driven by the energy price shock and because EU economies have still not fully recovered from the pandemic.

Despite the rate hikes, real GDP growth in the EU is expected to be 2.7 percent in 2022 and 1.5 percent in 2023.