Development of the interest rates of loans to the private sector and

On the basis of the dynamics of liabilities of households and non-financial corporations to the bank- ing system and interest rate fluctuations, this annex makes an assessment of the changes of the inter- est payment burden and its possible development in the future. It also assesses the impact of these changes on the capability of the main banking system debtors to service their financial liabilities.

Loans to the private sector are the most significant part of the banking system assets, while house- holds’ and non-financial corporations’ debts to monetary financial institutions account for about one- fourth in the composition of their financial liabilities. The financial situation of households and non- financial corporations and their proper compliance with liabilities assumed have an impact on the quality of the banking system loan portfolio and profitability. The pricing policy of loans to the private sector applied by banks, which is determined by the risk of default and the situation in the inter-bank market, defines the interest payment burden of debtors and their capability to meet their financial obligations.

The interest payment burden is determined by two factors: first, the size of financial liabilities and second, the interest rates paid. If households and non-financial corporations increase their liabilities to the banking system and other factors remain unchanged, the interest payment burden becomes heav- ier and vice versa. Similarly, with an increase in interest rates, ceteris paribus, the private sector pays higher interest to the banking system for its financial liabilities and vice versa. This annex does not make a thorough assessment of the changes of the private sector liabilities to the banking system43_,

but analyses the contributions to the interest rate developments. Such a choice was determined by the fact that the private sector may have a relatively stronger influence on the liabilities assumed and the interest payment burden directly depending thereon, while the interest rates payable on loans are more influenced by bank costs of attracting credit resources and by interest rate margins.

Interest rates on loans to households and non-financial corporations are grouped into fixed (fixed for over one year) and variable (fixed for less than one year). Because of higher fixed interest rates to the private sector, they are less attractive, therefore, only one-tenth of new borrowers have fixed their rates for a period of more than one year. Given the fact that three-fourths of loans to the private sector are denominated in euro, the effect of Lithuania‘s interbank rates to the interest payment bur- den is limited. Also, taking into consideration the characteristics of the loan portfolio to the private sector in Lithuania, interest rates paid for liabilities to the banking system are basically determined by confidence in the euro area interbank market (the latter is markedly impacted by the monetary policy implemented by the ECB), bank borrowing costs and the risk premium set by banks, which depends on the assessment of the default risk.

43 _{A more detailed analysis of the contributions to the changes of the loan portfolio in Lithuania is given in Annex 1 ”Sharp Slowdown of Credit}

Growth: Consequences of Supply and Demand” of the Financial Stability Review of 2009 prepared by the Bank of Lithuania. Chart A. Contributions to monthly interest rates paid

by the private sector for loans granted by banks

Chart B. Contributions to average weighted interest rates of new loans to the private sector (12-months moving average)

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Before the economic downturn, households and non-financial corporations rapidly increased their liabilities to the banking system. Therefore, the interest payment burden in 2006–2008 increased by more than LTL 60 million annually on average. To ensure the price stability, the ECB implemented re- strictive monetary policy and increased interest rates of the main refinancing operations (key interest rates) from 2.00 per cent at the end of 2005 to 4.25 per cent in mid-2007. The euro area interbank market made a respective reaction and the rising interest rate contributed to growing debt servicing costs – interest rates on new loans to the private sector soared by more than 1.5 times within the said period in Lithuania. Despite the decisions of the ECB to discontinue a further increase of the key in- terest rates, several financial system participants faced liquidity shortage, some of them bankrupted, and an intensifying pressure in the interbank market continued to push up the price of borrowing. Although the risk of lending to the private sector was not high and the margin fell only insignificantly during the economic expansion, interest rates of new loans to the private sector almost doubled in Lithuania from early 2006 to the end of 2008. Given that the development of interest rates of new loans determines almost without delays the respective dynamics of the banking system loan portfolio (stock) interest rates, which are taken as a basis for the assessment of the interest payment burden, during the said period interest rate payments of the private sector to the banking system grew by almost LTL 30 million every year on average. The interest payment burden of households and non- financial corporations reached its peak in October 2008 at LTL 375.9 million per month.

When economic downturn and the slowdown of the economic activity materialised, the banking system debtors faced financial problems and the loan repayment burden for a part of them became unbearable. As the amount of non-performing loans and loans overdue increased, the quality of the loan portfolio deteriorated. The banking system attempted to compensate an increased credit risk and mounting losses by raising the loan interest rate margin – from the beginning of 2009 to the end of 2010 it expanded by 1.5 p. p. This could have increased the tension among the private sector debt- ors even more; however, in the environment of the economic recession, the ECB started to implement an expansionary monetary policy and within a short period of time reduced the key interest rates to historically low levels. The situation in the euro area interbank market improved markedly and the av- erage weighted 6-month interbank interest rates dropped by 3.9 p. p., more than two times the previ- ous increase of the lending margin to the private sector. A lower interest rate of the banking system loans allowed households and non-financial corporations to reduce the interest payment burden by LTL 70 million on an annual basis in 2009–2010. Also, during the said period the private sector reduced its liabilities to banks by 14.4 per cent, resulting in the annual decline of the interest payment burden of almost LTL 20 million. In the second half of 2010, the interest payment burden of households and non-financial corporations to the banking system stabilised at LTL 200 million per month, and, com- pared to the level before the economic downturn, has become twice smaller. Therefore, the financial situation of the indebted private sector is relatively less tense and banking system faces a weaker pres- sure related to the loan portfolio quality.

In the environment of lower interest rates and the declining portfolio of loans to the private sec- tor, the share of financial flows allocated for the payment of interest decreased. In 2010, households spent about 2 per cent of their disposable income for interest payments. This amount was lower by one-fourth than the average in 2008–2009. The interest payment burden decreased for non-financial Chart C. Development of interest rates and the

Harmonised Index of Consumer Prices in the euro area

Chart D. Development of interest rates of the loan portfolio and on new loans to the private sector in Lithuania

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corporations as well: in 2010 the payment of interest accounted to about 4 per cent of gross profit, one-third44 _{lower than in 2008-2009 on average. With improved solvency of the private sector, the risk}

of bank lending to this sector declined and the growth of the margin slowed down in the beginning of 2011.

The ECB monetary policy, which significantly affects the interest payment burden of the private sector in Lithuania, continued to be favourable for the last two years. After the reduction of the ECB’s key interest rate to historically low levels, liquidity in the interbank market improved, while the bor- rowing costs and the interest payment burden to retail customers became lower. However, with the recovery of the euro area economy and the growth of prices exceeding the acceptable level at the end of 2010 and in the beginning of 2011, discussions that the ECB would increase key interest rates to maintain the price stability intensified (ECB raised interest rates at the end of April 2011). The reac- tion of markets to this shift was instantaneous: in the beginning of May, 3-month EURIBOR futures average interest rate for the period of 2011 to 2012 was about 1.5 times higher than in the beginning of January. Around 90 per cent of new loans to the private sector in Lithuania were granted in euro with the interest rate fixed for a shorter than one year period, as the interest rates of such loans were the lowest in the whole period of monitoring since the end of 2004. When borrowing at the small- est price, households and non-financial corporations assume the interest rate risk, which in this case depends directly on the situation in the European interbank market, while the latter depends on the monetary policy implemented by the ECB (with no regard to the development of margin, which is affected by peculiarities of individual debtors). In the context of the recovering euro area economy and increasing prices, the ECB aims at ensuring price stability by tightening the monetary policy and increasing key interest rates. This policy results in the growth of the interest payment burden of the private sector (with other factors unchanged).

An increase in the key interest rate by the ECB and the rise of the borrowing costs in the interbank market cause the growth of the interest rates of new loans, which determines higher interest rates of the banking system loan portfolio almost without delay. The development of these interest rates and liabilities to the banking system has essential influence on the dynamics of the interest payment burden. In the context of ECB implementing a restrictive monetary policy and 1 p. p. increase in the interest rate for private sector loans (assuming that this interest rate growth takes place at full scope immediately and other factors do not change), households’ interest payment burden in March 2011 would be LTL 22.4 million larger and non-financial corporations would pay LTL 23.2 million more inter- est per month for their liabilities (i.e. 22.4 % and 24.7 % more, respectively). An average household with a loan for house purchase after the said increase of the interest rate would have to additionally allocate about LTL 108.6 or 28.2 per cent more per month for interest payments.

In order to decrease borrowing costs, households and non-financial corporations assume the inter- est rate risk, which in the case of Lithuania depends on the business cycle of the euro area. With the deterioration of the economic situation in the euro area and the ECB implementing an accommoda-

44 _{For comparison, the data of total disposable income of households and gross profit of non-financial corporations are used, with no regard}

to their liabilities to the banking system.

Chart F. Effect of the interest rate change on the monthly private sector interest payment burden (immediate impact, with other factors unchanged; March 2011)

Chart E. Three-month EURIBOR and values of its futures

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tive monetary policy, euro-denominated variable interest rate loans allowed to reduce the interest payment burden and contributed to the better quality of the loan portfolio. When the euro area countries enter the upturn phase of the economic cycle, the pressure to increase historically low key in- terest rates is strengthening, therefore the interest payment burden for the private sector in Lithuania will rise in the short run. However, the growth of this burden will be partly offset by the decline of liabilities to the banking system and the stable margin, which will not grow further due to the improv- ing financial situation of borrowers.