Financial Management - Beware of the interest rate trap
In recent years, global economic events and political developments have had a significant impact on inflation and the interest rate level in Europe. Before the pandemic, inflation was at a persistently low level; however, from 2021 the global economy experienced a marked rise in inflation rates and, as a consequence thereof, also in interest rates. In the meanwhile, the situation has admittedly eased, but it remains problematic.
Developments in inflation and interest rate levels
After an increase in the inflation rate from 0.5% to, initially, 3.1% in 2021 - which was induced by the COVID-19 pandemic and the concomitant measures and/or impacts (including a temporary reduction in VAT rates as well as the decline in prices for petroleum products) -, in 2022, the inflation rate continued to go up and was ultimately 6.9%. The reasons for this were, most notably, the Russian offensive against Ukraine and the resulting energy price increases. In 2023, the inflation rate remained at the consistently high level of 5.9%, which led to interest rate hikes by the European Central Bank (ECB) in order to counter the inflation. Consequently, the main refinancing operations rate went up, in several steps, from 0% at the start of 2022 to 4.5% in September 2023.
Impact on lending and business practices
The interest rate hikes resulted in a significant increase in the financing costs for businesses. Many companies that previously benefited from low interest rates and made extensive use of debt financing now find themselves confronted with considerable additional costs.
1. Lending practices
To begin with, it was the credit institutions that were affected. Their business models are based on maturity transformation, a process where short-term deposits are converted into long-term loans. The rapid increase in interest rates has made such transformations difficult. Nevertheless, in 2023, banks, cooperative banks and especially the Sparkassen [savings banks] were able to generate high profits because they achieved high interest income by providing capital and, at the same time, had only small interest expenses due to the low deposit interest rates.
2. Growth in the number of
insolvency and restructuring cases ...
Many small and medium-sized enterprises are now facing considerable challenges because of higher financing costs. This has already resulted in an increased number of insolvencies on account of the fact that many companies had tended to underestimate the consequences of the turnaround in interest rates and were not able to bear the additional costs.
According to a survey by the German Finance Magazin - which was carried out in cooperation with the consultancy firm Struktur Management Partner -, 84% of restructuring experts consider the high levels of corporate debt that ensued from the phase of low interest rates to be problematic. During the phase of low interest rates, many companies took on debt at favourable conditions without taking into account the effects of an environment with rising interest rates.
... due to the increase in financing costs
As a result of the turnaround in interest rates, the interest expenses paid to banks increased massively; this led to considerable pressure and, ultimately, to numerous insolvencies and/or restructuring cases. Besides the turnaround in interest rates and the higher (re)financing costs associated with them, the current sluggish growth in Germany, among other things, is also compounding the difficulties for companies; therefore, leading indicators from the Halle Institute for Economic Research (IWH) are implying that no noticeable easing of the situation can be expected in the coming months and it is likely that the number of insolvency and restructuring cases will continue to go up.
3. Problems in the area of takeovers - more difficulties for M&A transactions
Private equity firms, which frequently have high debt levels due to leveraged buyouts, as well as their portfolio companies have been particularly severely affected by the turnaround in interest rates. Higher interest rates have considerably increased the cost of servicing debt, which generally has to be financed out of the cash flows of the acquired companies. Consequently, the financial burdens of these companies have gone up and are constraining their ability to refinance debt or to make acquisitions.
M&A transactions can be a solution for companies in financial distress. A takeover can provide a company with new financial possibilities. The turnaround in interest rates has however made this path more complicated because financing such transactions has now become more expensive and riskier. That is why companies need to find alternative ways to ensure their liquidity and adapt their business models.
Conclusion and Outlook
Persistently high inflation and the turnaround in interest rates have far-reaching implications for the economy and the financial stability of companies. In view of the higher financing costs and an uncertain economic situation companies need to re-think and adjust their financial strategies. This will require not just financial discipline, but also innovative approaches in order to remain competitive and stable in the long term.
The coming months will show how much success companies can achieve in implementing these adjustments and what long-term impact the current economic developments will have on the business world. Despite an inflation rate that is falling once again and the reduction of the main refinancing operations rate to 3% by the ECB in December 2024 and to 2.75% in January 2025, nevertheless, the environment still remains under pressure.
