The Impact of High Interest Rates on the Economy and the Future Well-Being of Latvia

Recently, the focus in the context of interest rates has been on mortgages, which is, to put it mildly, not quite right when we think about the future well-being of our country as a whole. Mortgage loans have come into the focus of the Saeima’s attention, most likely because, by adopting a decision that pleases the people, the deputies can completely cover their expensive and extensive lifestyle for a while at the expense of other taxpayers. It is true, however, that it does not fundamentally solve the biggest problem of high loan rates in the economy. Maybe even the opposite. In addition, they will ruin the lives of those trying to save money through bank deposits, potentially more than those who have had the good fortune or misfortune of getting a home loan. Similarly, nothing good awaits those who are still planning to get a bank loan, regardless of whether it is a household or a company. However, it would be worth thinking more about the latter at the moment, because things are so bad in certain sectors of our economy that if companies cannot cope with their credit obligations, problems will arise for households as well – regardless of whether they have received an interest rate discount for a mortgage loan or not.

Can be reduced earlier

What is happening in our exporting sector is a mirror of the development of events in the eurozone as a whole. It is this development that could force the European Central Bank to cut interest rates faster than previously expected. At the moment, the situation is very ambiguous. It is believed that the last rate hike could be adopted as early as the ECB’s September meeting. However, if for some reason inflation in the euro area deviates from its current downward trajectory (for example, as global conflicts widen, commodities could rise, pushing inflation back up), the central bank could raise interest rates again. At the same time, there have also been talks on the sidelines of the financial market about the fact that, taking into account the increasingly pronounced malaise of the economy of the European monetary union, the ECB could start reducing rates earlier than expected. If earlier it was believed that the summer of next year could be the moment when the ECB could start a modest reduction of rates, now the talks about next spring are already starting to appear. The previous increase in interest rates has been felt most severely by the Baltic States and some other countries, where the proportion of variable loan interest rates is more pronounced in private sector lending. In the so-called old Europe, fixed rates are used more and direct interest rate increases are not even directly felt in many places. In a behind-the-scenes conversation with the “Independent”, one of the financial market and economic experts admitted that, for example, a country like Italy can tolerate the current high interest rates only for a relatively short time, but then problems will begin. It should be added here to what he said that, as the countries already expected that interest rates would rise last summer, previous loans were largely refinanced at lower rates. By the way, also in Latvia. Any rate-fixing or refinanced loan sooner or later comes to an end, at which point rates are high, but the need for loans increases, thus spurring even more rate hikes in the bond market and higher borrowing costs. As the yield rates of government bonds increase, private sector loans in commercial banks may also become more expensive, because the money market operates according to the principle of “connected vessels” and everything that happens ultimately threatens the financial market with a wider avalanche of troubles.

Manufacturing and construction as an indicator

The fact that the situation in the European economy is not good and thus the ECB may be forced to act to reduce rates can be judged by several factors. This can be seen most clearly by looking at the already published estimates of the economic performance of individual currency zone countries in the second and third quarters of this year. The common direction of the economically largest countries in the Eurozone is aimed at an increasingly pronounced slide towards recession – with some countries experiencing ever-closer to zero economic growth or already entering the so-called negative territory, as the gross domestic product decreases. The third largest export partner of Latvia, Germany, also belongs to the latter, where both manufacturers and the construction sector feel the problems. The construction industry in Germany is expected to shrink by 4.4% in real terms in 2023, according to an article by Yahoo! Finance”. A particularly unfavorable situation has currently developed in the construction of residential houses, which is largely directly related to high interest rates. The fact that things are going badly in Germany and other parts of Europe, for example in Sweden, which is not in our currency zone, can be seen from our industrial data. For example, the volume of timber production in the nine months of this year was 9.9% lower than at the same time last year, according to the data of the Central Statistics Office. It has been even worse in the production of non-metallic minerals, which is closely related to construction, where the volumes fell by 18.5% during the mentioned period. But in the mining and quarrying industry, which is very subordinate to the mentioned sector, the volumes fell by 20.6% in the same period of time. Homes also need to be furnished after their purchase, but these processes have also slowed down both here and elsewhere in Europe, which is evidenced by the fact that in the nine months of this year, the output of the furniture industry in Latvia was 19.4% lower than in the same period last year.

What is expected in Latvia?

Our manufacturers are mainly export-oriented. The difficulty of selling in many segments is obvious. But Europe’s biggest economic challenges are yet to come if interest rates remain at current levels. Presumably, the ECB also understands this. Given the experience of the past ten years, it is unlikely to be interested in waiting for another financial collapse to hit the currency area. Therefore, it is reasonable to believe that the central bank could soon return to lowering interest rates. Latvia will hardly be destined to enjoy this process in a qualitative way, because the local money market will most likely be distorted. Banks will seek to recoup losses from lower mortgage rates elsewhere. So, for savers, the interest rate is likely to decrease, but for new borrowers, it will increase. Also for companies. The end result is that the already difficult economy will have to pay more for a bank loan than before, which, among other things, will also make investments more expensive. Moreover, it can happen already at a time when interest rates on loans in the financial market have started to decrease. In recent years, the inability to assess the expected development of the situation “two steps ahead” has become an increasingly common phenomenon in Latvia. This also applies to the attempt by members of the Saeima to intervene in the financial market, which is likely to cause more losses than gains.

2023-11-07 03:15:19
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