Low and negative interest rates hurting Cyprus
A policy of lowering interest rates is usually aimed at reigniting the economy. Reduced interest rates are supposed to encourage borrowing to support increased spending by businesses and households that especially through bank financed productive investments contribute to generating sustained economic growth. But in the case of Cyprus with many businesses and households over-borrowed and un-creditworthy there has been a reluctance by banks to extend risky loans to such clients even if these customers were prepared to take on more debt carrying lower interest rates. Since June 2014 when the ECB reduced its overnight rate to a negative level, bank credit to the Cyprus private sector excluding loans transferred to credit acquiring companies has decreased substantially with little resurgence in bank-financed investments outside of the construction sector taking place.
The asset portfolio alternative for Cyprus banks has been to purchase zero risk-weighted government bonds. However, with bond yields very low because of the easy monetary policies of the ECB and purchases of sovereign bonds strictly limited by ratios of bond holdings to capital regulated by the bank authorities, Cyprus banks have had little latitude to boost their revenue with interest income from holding more government securities. As a consequence banks have been left with large amounts of excess liquidity mainly in the form of cash balances with Central Banks earning negative interest.
Take the situation of Hellenic Bank as revealed in their Annual Report for 2020. At end-2020 the asset portfolio was valued at 15.9 billion euro including over 5 billion euro in debt securities of which were €2.9 billion of non-tradeable Cyprus government bonds. In addition the bank had 6.1 billion euro of outstanding loans and advances, and €3.6 billion of cash balances at central banks on its balance sheet. Interest income from debt securities and loans and advances excluding accrued interest on NPLs was estimated at just €263.4 million in 2020 and failed to cover the expenses of the bank estimated at €283. 8 million including over €11 million in interest paid to central banks.
Hence, while private businesses and households do not appear to have benefitted to any significant degree from low interest rates, banks have had their profitability eroded by low and negative interest rates.
Moreover, there should be concern that low interest rates are doing even more longer-term damage to the economy and society. It is no secret that the governments of southern European countries much prefer to finance their deficits by borrowing at current extremely low interest rates through issues of Eurobonds rather than availing of grants and loans from the EU that require conditionality in using such funding. This means that government debt levels in southern Europe have risen substantially, while resources have been allocated in markedly different ways from what is recommended by the EU in their country reports.
For example, mainly through large Eurobond issues the debt of the Cyprus government most strikingly increased by 6.5 billion euro between end-2016 and end-February 2021, rising to 26 billion euro or more than 124% of GDP in just over four years. Yet, government capital outlays including development expenditures have fallen from €370 million in 2016 to an estimated €300 million in 2020 reflecting the fact that the huge increase in external borrowing has been only used to finance higher government current expenditures as against investment projects and reforms recommended by the European Union. Such debt developments and its unproductive use are not only diminishing the growth potential of the Cyprus economy, but will widen inequalities by increasing the future burden of taxes on the younger generation and inevitably may bring into play fiscal austerity measures that usually and disproportionately hurt lowly-paid private sector employees.
Furthermore, with extremely low bank deposit rates younger persons at least in Cyprus do not have the traditional interest-bearing “safe” saving instruments available in which they can accumulate funds in order to purchase a house and be able to raise and educate offspring. And their more elderly relatives, some with much reduced interest income to supplement their pensions and others with heavy private debt obligations, can hardly help. The birth rate of Cypriots has been falling and with the financial capacity of the younger generation reduced among other things by ultralow interest rates on saving deposits the demographic future and growth prospects of Cyprus are looking bleak.