• From the shock of floating-rate loans to "locked-in" public debt and the paradox of low deposit rates

The impending interest rate hike by the European Central Bank (ECB) comes to interrupt the period of gradual reductions we experienced recently, impacting the Cypriot economy on multiple levels. The effects are reflected differently across borrowers, depositors, businesses, and public debt, due to the unique characteristics of the domestic market.

Cyprus traditionally has a high percentage of loans with variable interest rates (primarily linked to Euribor or the ECB's base rate). Therefore, those with older housing or business loans on floating rates will see their monthly installments increase immediately, restricting their disposable income.

However, it is a positive factor that in recent years Cypriots have turned en masse toward fixed interest rates. While in 2022 nearly 100% of new mortgages were variable-rate loans, this figure has currently dropped close to 12%, offering protection to those who borrowed recently.

The increased cost of money is expected to act as a disincentive for new ventures. The real estate market, a traditional pillar of the Cypriot economy, is facing an inevitable slowdown. Banks, aligning with new guidelines, are becoming stricter in granting new credit. The purchasing power of domestic buyers is being compressed, forcing many young couples and small-and-medium enterprises (SMEs) to put their housing and investment plans "on ice."

The real estate sector, a cornerstone of the Cypriot economy, may experience a slowdown in demand from domestic buyers, although external demand (from foreign investors) often acts as a countervailing force.

Although in theory a rise in interest rates favors savings, in Cyprus the pass-through of rate hikes to deposits is traditionally very slow and limited. As banking circles explain, "this is due to the fact that Cypriot banks possess exceptionally high excess liquidity (with LCR ratios exceeding 310%, compared to the European average hovering near 186%), meaning they have no interest in attracting new deposits, thus keeping deposit rates at low levels compared to the rest of the Eurozone."

On the other hand, Cypriot businesses, which rely heavily on bank lending for working capital, will face increased financial expenses. Consequently, many development projects or business plans may be temporarily frozen, as the return on investment will need to outperform the increased borrowing costs.

The impending interest rate hike by the European Central Bank causes justifiable concern regarding the trajectory of the economy; however, the case of Cyprus’s public debt presents a different picture compared to private loans. While thousands of households face immediate increases in their installments, state coffers maintain strong defenses, preventing a sudden fiscal derailment.

According to government sources, "the main reason for this stability is the structure of the Cypriot debt. The largest portion of it is 'locked' into fixed interest rates, so bonds issued in previous years at historically low costs are unaffected by Frankfurt's current decisions. The 'installments' paid by the state to service existing debt remain unchanged, providing significant breathing room for the state budget."

However, the real challenge will emerge gradually when the Republic of Cyprus is called upon to enter international markets once again to refinance maturing bonds. New issuances will inevitably be burdened with the elevated interest rates of the period, raising the average borrowing cost in the long run. Even so, the Ministry of Finance possesses two significant weapons: the "liquidity buffer," which allows the state to avoid borrowing during periods of high volatility, and continuous fiscal surpluses.

As Cyprus's public debt steadily declines as a percentage of GDP, the country's credibility remains intact, at least in the eyes of foreign investors.

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Source: Brief