ECB roars and euro zone periphery shudders
March 9, 2011 - 0:0
Vulnerable euro zone countries may be able to digest a series of modest interest rate hikes without major pain, but more aggressive tightening would hit consumers and banks, putting ambitious budget goals at risk.
European Central Bank President Jean-Claude Trichet surprised markets on Thursday by signaling a rise in the bank's benchmark rate, currently a record low 1.0 percent, as early as next month to counter rising inflation in the 17-nation currency bloc.He also made clear that the ECB would not be embarking on a series of substantial rate increases. A Reuters poll on Friday showed most economists now expect three small hikes this year, taking the headline rate to 1.75 percent.
The countries that are most vulnerable to the tightening cycle are Ireland, Greece and Spain -- all countries with a high percentage of floating rate mortgages, fragile banking sectors and sizable consolidation programs in place.
Removing the cushion of low mortgage rates from tens of thousands of Irish homeowners, for example, could tip many into arrears, creating a new black hole for banks already pushed to the brink by eye-popping losses on commercial property loans.
""Ireland simply cannot handle an increased interest rate burden,"" said Ray Kinsella, a professor of banking and financial services at University College, Dublin. ""What a rate rise does is it opens up a second front in Ireland's banking crisis.""
Data this week from the Irish central bank showed the number of residential mortgages in arrears had jumped by over half in 2010 and that one in 10 mortgages was either in arrears or restructured due to financial distress.
Around 80 percent of Irish residential mortgages are on variable interest rates and 50 percent track the ECB rate. Many of those loans were signed at the peak of Ireland's property boom, meaning holders are among the least able to absorb future increases.
----Impact on investment, competitiveness
In Spain, almost nine out of 10 mortgages are tied to the 12-month Euribor rate, which had risen over 25 basis points this year even before Trichet's hawkish news conference, adding 250 euros to the annual cost of servicing a 100,000 euro loan.
But Holger Schmieding, an economist at Berenberg Bank, played down the impact of modest rate hikes on the Spanish economy, estimating the annual impact of a 50 basis point hike at 0.1 to 0.2 percentage points of gross domestic product (GDP).
""We're not talking about anything dramatic,"" he said, predicting that a pickup in global growth would fully offset the economic impact of a series of small rate increases.
""If the ECB were to overreact however, say go to 2.5 percent, then the impact would be felt. It could lop off half a point of Spanish growth.""
An ECB working paper dating back to 2001 estimates a rate increase of 100 basis points sustained over a two-year time period would leave GDP in the broader euro zone one percentage point lower than its ""steady state"" value after three years.
It describes the negative impact on GDP as ""lagged and gradual,"" citing the depressing effect of higher rates on investment and competitiveness, based on an initial appreciation in the nominal exchange rate.
The euro pushed up to a four-month high against the dollar after Trichet's news conference on Thursday and some economists predict it will rise further in the months ahead if the U.S. Federal Reserve keeps its rates at a record low through 2011.
That could hamper the ability of export-driven countries like Ireland, which is highly exposed to U.S. demand, to rebound at a time when domestic demand is depressed by steep wage and pension cuts. ----Higher funding costs
In Greece, an increase in euro zone rates will translate into higher funding costs for banks which have grown dependent on the ECB for liquidity after losing access to interbank funding because of the country's sovereign debt crisis.
ECB funding to Greek banks has risen to 95 billion euros, or about 19 percent of the banking system's total assets. A quarter-point rate increase by the ECB would mean 237 million euros of additional interest expense for Greek lenders.
Analysts say the hit on their net interest income (NII) can be partly mitigated by asset-side re-pricing. But given that a large share of loans are floaters, higher borrowing rates could have a negative effect on non-performing credit, which is rising as the economy enters its third straight year of recession.
""There is bound to be an impact, especially now that household budgets are stressed and every euro counts,"" said the head of credit at a large Greek bank who requested anonymity.
In Portugal, the country that is most at risk of a euro zone bailout following the rescues of Greece and Ireland last year, economists said a series of small rate increases could crimp exports and weigh on consumers whose debt levels are high, but would be tolerable.
The impact on Italy will be mitigated by low private sector debt levels.
""I don't think you'll find anyone who would cut their forecasts for Italian growth this year or next on the basis of the more aggressive rate hikes expected from the ECB,"" said Unicredit economist Marco Valli. ""A potential oil shock is a far more significant threat to growth.""
(Source: Reuters)