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Euro Zone Faces Potential Contraction as Interest Rates Bite

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The Eurozone Faces Challenges as Interest Rates Rise

The euro zone is currently facing a unique situation when it comes to interest rates. On one hand, the official interest rate set by the central bank is at record levels in an effort to cool the economy and curb inflation. On the other hand, the interest earned by companies and individuals on their investments has been increasing, supporting growth. However, as more debts come due for refinancing next year, there are concerns that the economy may not fare as well as expected.

Since the 2008 economic crisis, European citizens and corporations have been quietly accumulating financial assets. According to data from the European Central Bank, euro zone companies, excluding banks and insurers, held financial assets worth 15 trillion euros ($16 trillion) in the first quarter of 2009. By the second quarter of 2023, that figure had grown to a record 34 trillion euros. Over the same period, the total value of household assets, including deposits, currencies, and shares, rose from 17 trillion euros to 29 trillion euros.

The pandemic era has accelerated this trend of accumulating investments, thanks to fiscal stimulus and government support to households and firms. This has resulted in a robust private sector balance sheet, countering the efforts of the European Central Bank to reduce inflation. Despite the central bank raising its benchmark rate from minus 0.50% in July 2022 to a record 4% in just over a year, the euro zone economy grew by 3.4% last year. Though growth is expected to shrink to 0.7% this year, it is still better than the recession that many economists previously predicted.

The increased interest income has helped households weather the storm. According to ECB data, households paid 46 billion euros in interest on their borrowings in the three months to June, more than four times the level at the start of 2022. However, they also earned 66 billion euros in interest on their assets during the same period. This resulted in the highest net interest income in 14 years. The windfall for households can be attributed to the composition of their balance sheets, with a significant portion being in currencies and bank deposits that respond quickly to rate changes, while their liabilities are mostly in the form of loans with fixed interest rates.

In contrast, non-financial companies rely more on shorter-term bank loans, with almost 80% having a maturity of less than one year. As a result, these companies experienced a negative net interest of 19 billion euros in the second quarter of 2023. However, since 2020, companies and households have received a net interest payment of 6 billion euros, and in June this year, they still received interest payments of about 660 million euros.

The financial gains have contributed to euro zone growth. Private consumer expenditure, accounting for around half of the bloc’s GDP, increased by more than 4% per year in both 2021 and 2022. Gross fixed capital formation, a measure of corporate investment that makes up about a quarter of euro zone GDP, also grew faster than usual in those years.

Certain countries and companies have been the beneficiaries of these gains. For example, France has seen household financial assets reach 245% of its GDP, while liabilities only amount to 76% of economic output. Oil giant Shell has also experienced a significant increase in cash and short-term investments, rising from $18 billion in 2019 to $40 billion in 2022, helped by resurgent crude prices.

However, as interest rates rise, individuals and companies may need to tighten their belts. Companies will be the first to face higher interest bills. According to S&P Global Ratings, nearly 45% of the 1.4 trillion euros owed by European investment-grade companies will come due in 2024 and 2025. An additional 700 billion euros will mature in 2026, resetting at higher rates. Interest payments on companies’ outstanding bonds and loans have already risen from 1.1% of nominal GDP in 2021 to 1.6% in 2022. Oxford Economics estimates that this figure will reach 2.8% this year and 3.1% in 2024.

Homeowners with mortgages, which account for around 27% of euro zone households, have yet to feel the full impact of higher rates. This is because over half of all new housing loans in recent years had fixed rates for 10 years, compared to less than a third a decade ago. Additionally, nearly 45% of all consumer loans in the euro zone have interest rates fixed for five years or more. As a result, payments on all outstanding loans will rise by a relatively small 0.3 percentage points of GDP this year and next. The impact will be greater in countries with more variable-rate loans, such as Spain and Italy, while countries like France and Germany, where fixed rates are more common, will feel almost no impact. However, as mortgages reset to higher rates, the repayment bill for households is expected

More detail via Reuters here… ( a )

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