I would like to start with a brief explanation of the most important messages from the OFS and then answer your questions.
Economic prospects
First of all, I would like to consider the economic prospects. Since the high inflation peak last autumn, (core) inflation has started to decline, but is expected to remain above 2% for some time to come. That is why central banks have further tightened monetary policy over the past year. With ten interest rate increases in fourteen months, the ECB has raised the policy rate from -0.5% to 4.0%, which is a fast pace from a historical perspective. Rising interest rates have made it more expensive for households and companies in the Netherlands to borrow money. These tighter financial conditions are becoming increasingly apparent in the economy, and are necessary to bring high inflation back in line with our 2% target. We therefore see that economic growth in the Netherlands is slowing down. At the same time, the labor market is expected to remain tight in the coming years, which will keep unemployment low. This continued tightness is contributing to higher wage growth and the gradual pace at which inflation is normalizing.
Risks in transition to higher interest rates
The rapid transition to higher interest rates also changes the risks to financial stability. The higher interest rates in themselves have a positive effect on the financial system. For example, the increase in banking profits and higher coverage ratios at pension funds show that higher interest rates are in principle beneficial for financial institutions. Investors in financial markets also appear to be pricing in risks more recently, which means that investors have less incentive to invest in riskier asset classes. But no advantage without a disadvantage: the transition to higher interest rates can also expose previously accumulated vulnerabilities and create new risks for financial stability. I would like to explain two important examples of such risks, which are also included in the Overview of Financial Stability.
First of all, the transition to higher interest rates is negative for the debt sustainability of governments, because the higher interest rates put a greater burden on government budgets. Despite the still relatively low government debt, this also applies to the Netherlands. Adjustment is necessary to comply with the budget rules in the future and to have room for stabilizing budget policy; such as during the Covid-19 pandemic and the support to households to compensate for energy price increases in 2022. I therefore support the advice of the 17th budget space study group to the next cabinet to change the course of budget policy. The study group in which colleague Olaf Sleijpen participated on behalf of DNB.
In addition, we expect credit risks for banks to increase in the near future. The higher interest rates increase refinancing risks, especially for companies. For example, 56 percent of the total Dutch corporate debt will mature within two years or will be subject to an interest rate review. These companies will therefore have to deal with rising interest costs in the near future. The capacity of companies to repay debts has also decreased due to high inflation. Both developments contribute to increasing credit risks at banks. These risks are also visible in the data with a delay, which makes banks vulnerable to potential losses in the future. At the same time, Dutch banks have a good capital position and DNB has taken macroprudential measures in recent years that contribute to the resilience of banks, such as increasing the countercyclical capital buffer. When designing their capital policy, it is now important that banks also take the increased risks and future resilience into account.
Commercial real estate risks
With regard to increasing credit risks at financial institutions, I would like to focus in particular on the Dutch commercial real estate market. As in other countries, our commercial real estate market is also under pressure. For example, transaction prices have fallen by 13% since mid-2022. The price drop follows a combination of cyclical and structural changes. Construction and financing costs have risen due to high inflation and high interest rates. In addition, structural changes, such as the increase in working from home and online shopping, lead to less demand for office space and retail properties.
At the moment we do not see any problems at financial institutions exposed to commercial real estate. There are no signs yet at banks that credit risks are materializing, but this could change quickly if interest rates remain at a higher level for a long time. Insurers and pension funds are directly exposed to drops in the price of commercial real estate; market valuations have a direct impact on the balance sheet. Since pension funds and insurers largely invest in commercial real estate through investment funds, in this OFS we specifically look at the risks associated with real estate investment funds. On the positive side, we conclude that the risks associated with Dutch real estate investment funds appear to be controlled. This is partly because the repayment frequency of these funds is tailored to the illiquid nature of the real estate investments.
This concludes my introduction.