Companies and households are adapting to higher interest rates
The steps taken by the central banks of the euro area to calm high inflation have made borrowing more expensive, but the capacity of people and businesses to borrow remains good. The sluggish growth in bank deposits and the rise in central bank interest rates have led the banks to raise their interest rates on term deposits, and whether they rise further will also depend on the choices made by the clients of the banks.
Tighter monetary policy at the European Central Bank has raised interest rates on loans and slowed growth in loans in Estonia and elsewhere in the euro area. This is the goal of raising interest rates as doing so then restrains generally high inflation. The rise in interest rates on new loans has been fairly equal across the whole of the euro area, and the interest rates on new loans issued to households and businesses have been 2-3 percentage points higher than a year earlier. Estonian businesses and households gained substantially from the period of low interest rates by taking loans with floating rates that were linked to Euribor. The higher interest rates are now however being passed very quickly into the loan servicing costs of loans that were taken out earlier. This has made people more interested in reducing the interest margins on those loans taken out earlier, which has noticeably increased the number of loan contracts being amended or refinanced.
The capacity of the banks to lend remains strong, but the deterioration in the outlook for the economy and higher risks have pushed the banks to tighten their lending standards a little. This means that the set of businesses and households that can borrow has become a little smaller, though the changes are not large. The average share of loan applications that were rejected last year was around the same level as in the previous year, and the average interest margin on new loans that were issued was even a little smaller both for companies and for households. The margin has declined even as the risks have increased, because competition pressures have grown a little. The banking market has become less concentrated, and the smaller banks have increased their market share. The ability of banks to reduce their margins is given further support by the largest part of the funding of the banks continuing to come from demand deposits, and so the cost of those funds has remained very low.
Rising interest rates and a weaker outlook for the economy have caused the opinion of businesses of the borrowing environment to deteriorate. Opinions first worsened immediately after the Russian invasion of Ukraine in February 2022, and then additionally in the second half of the year when interest rates started to rise. Estonian businesses considered overall however that their access to funding last autumn was about as good as the average for companies in Europe. Estonian companies are most concerned about higher interest rates on loans and about finding collateral for loans.
A lot of companies and households have taken a wait-and-see stance in making decisions about investment and borrowing because of the uncertainty about the outlook for the economy and the rapid rise in prices and interest rates. The earlier rapid growth in borrowing slowed at the end of 2022 in consequence. The rise in costs has weakened the capacity to borrow to some extent, but it is still quite good. Corporate sales revenues and profits have increased, and the buffers built up earlier in deposits and equity are substantial. The factor that has the biggest effect on people’s purchasing power and their ability to borrow is their job, and this factor remains favourable as unemployment is low. The current level of interest rates should not be beyond the means of companies and households in Estonia, and demand for loans will probably increase again as the outlook for the economy clears and confidence recovers.
The weak growth in bank deposits and the rise in monetary policy interest rates have encouraged the banks to raise their interest rates on term deposits. The amount held in term deposits has consequently started to increase at the expense of demand deposits, which are simply cash that is held on current accounts. As monetary policy interest rates rise, so the interest rates on term deposits may be expected to rise further as well. This also depends though on demand for loans and the need of the banks for funds. The interest rates on term deposits and the interest earned from those deposits also depend on the choices made by people and businesses about whether to continue holding their deposits mainly on current accounts or to start using term deposits more, which would put pressure on the banks to compete between themselves by offering higher interest rates to tempt client deposits.
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