The Impact of Rising Interest Rates on the UK Lending Market and Economic Stability

There are multiple macroeconomic factors that can impact the lending market for UK SMEs and Corporations/Large Enterprises. In the last couple of years, the sharp rise in inflation has resulted in the Bank of England trying to combat and curb the effects of inflation on the economy by hiking/raising interest rates in line with part of their mandate of price stability.

The Goldilocks Economy

Central Banks ideally want both inflation and interest rates in what can be classified as a sweet spot, described as the Goldilocks Economy, where there is:

• Economic stability
• Stable growth
• Maximum employment

Why Raise Interest Rates?

The reason central banks raise interest rates in a high inflationary environment is to make borrowing more expensive in order to reduce consumption. Interest rate increases are used to discourage borrowing, reduce aggregate demand, and encourage savings. Higher savings can result in more capital investment.

Essentially, central banks are trying to change consumer behaviour from the propensity to spend to the propensity to save, in order to reduce inflationary pressures on the economy.

However, the impact of interest rate increases can be deleterious to an economy as higher interest rates can result in the following:

• Increased cost of capital
• Increased interest payments
• Decreased demand for borrowing
• Reduced disposable income and consumption
• Increased propensity to save instead of spend
• Higher probability of rising unemployment
• Reduced economic growth
• Lower demand for property purchases
• Increased discount rate for stocks

Corporate Sector Challenges

When central banks raise rates, that then increases the corporate/private sector credit spread. This has had a negative impact on businesses' capital expenditures, in some cases their ability to finance their operating expenditures, and impacts their debt service coverage ratio.

In many cases, when central banks raise interest rates, the impact and pressure of interest rate hikes work with a lag of somewhere between 6 to 18 months, and therefore do not have an immediate impact on the economy due to fixed-rate debt that is termed out. Moreover, some hold the view that when you attempt to centrally plan the price of something, so in relation to interest rates, there is essentially no aggregate or neutral level for the entire economy. There is a spectrum of businesses that have differing levels of sensitivity to changes in interest rates. However, when the fixed rates mature, they have to be refinanced at higher rates of interest which in turn is then financed with more debt, affecting interest expense, debt servicing and, in turn, revenues, earnings, and free cash flow.

Although historically interest rates moving up to 5.25% does not seem significant enough to impact the economy, when you look at it on a rate of change basis, in which rates went from roughly 0.25% to 5.25% in roughly 18 months, that can be detrimental to the economy. This essentially contributed to creating the asset-liability mismatch on the balance sheets of the banks, which in the US, intervention was required by the Federal Reserve (central bank in the US) in order to avoid some banks from going under.

Tightening Financial Conditions

If the Bank of England stopped raising interest rates today and remained at 5.25%, just by rates remaining at that level for a period of time is a form of tightening. As someone’s loan is resetting higher every month, the BOE does not have to keep raising rates to tighten financial conditions further. They just need to keep interest rates higher for longer which is a form of consistent tightening. So, in a low-interest rate dependent economy in which some businesses depend on borrowing, debt has helped generate economic growth.

However, with a higher cost of capital, every month a company’s loan is coming due that needs to be refinanced at a higher rate of interest, cash flows are being allocated to interest expense as opposed to growth.

Capital Spending and Liquidity

In a world where there is a vast amount of capital spending, interest rates are pertinent, whereby you have to compare a cost of capital with a return on capital. In a world where debt levels have exploded since the 2008 financial crisis, the system is more about debt refinancing, and interest rates are less important. The volume of liquidity is essential. When there is a slowdown or reduction in liquidity, the ability to refinance proves difficult, resulting in a financial crisis.

Financial crises are not about failures to finance new capital but the ability to finance existing debts. Looking back over the last 30 years, all the major financial crises that occurred have basically been refinancing problems.

Post-2008 Financial Crisis

Since the 2008 financial crisis:

• Banks tightened lending standards and made credit less available to business
• Recent interest rate hikes have inverted the yield curve, indicating a recession
• Inverted yield curve affects bank net interest margins

As banks borrow short and lend long, they are essentially creating an artificial yield curve giving depositors close to 0% and lending at higher rates.

In some instances, however, some banks tend to lend aggressively late cycle, which is due to the fact late cycle yields are generally higher, therefore making the loan yield appealing for banks to lend, alongside the fact that late cycle fundamentals tend to look okay, as generally the unemployment rate is at its lowest historically before a recession occurs.

Inflation and Interest Rates

The rise in inflation and interest rates affects companies of all sizes. Some people believe it does not affect the larger corporations as much as SMEs, which in some cases can be true. However, SMEs are clients of large corporations, so therefore there is a spill over that will take a while. Rising inflation, mainly energy costs and rising interest rates, ultimately hits larger corporations also as there is a second-round effect with a lag. Generally, in previous inflationary periods in the past that have been demand stressed, businesses experience declining margins as consumers/customers are unable to absorb the increase in prices for a company’s goods or services.

Risks of Monetary Policy

There is the potential that the central banks have tightened monetary policy too far, tipping the economy into recession. This could be evident with the UK falling into a technical recession at the end of 2023, which showed up in the GDP print on the 14th of February 2024.

However, now with potential rate cuts on the horizon, they also run the risk of reaccelerating inflation, just as it seems central banks have been successful in their inflation fight. So, it seems central banks could be stuck between a rock and a hard place.

Long-term Low Interest Rates

With near 0% interest rates for over a decade, some believe:

• Raising rates to 5% may not significantly slow borrowing and spending, but have contributed to putting upward pressure on prices
• Central banks have raised borrowing costs causing an increased cost of servicing existing debt
• Businesses with pricing power have passed increased costs onto customers, whether that is an increase in a company’s raw materials, labour costs, insurance costs or higher interest costs.

Penalising Capital Investment

Moves by central banks to hike interest rates have penalised capital investment by:

• Rapidly raising the cost of capital
• Increasing the hurdle rate for investment

Some economic studies, in fact, show that central banks raising interest rates has less of an impact on consumption and therefore on the demand dynamic, but there is more of an impact on the investment function, as a 1% increase in financing costs, results in a 1% decrease in investment.

The Role of Debt in Business

Some view debt as a tool for businesses to:

• Borrow capital for investment opportunities
• Invest in plant and equipment generating income to service and amortise the debt
• Expand the productive capacity of the economy

The Debt Trap

Within a capitalist system, debt needs to exist for the growth of the money supply which in turn enables credit creation and in turn GDP growth.

However, the continuation of debt accumulation by governments, corporations/businesses and households may potentially lead to a debt trap, (or the worsening of a debt trap) or a crack-up boom.

Debt levels globally remain at near all-time highs and it seems central banks continue to intervene and kick the can down the road to avoid the day of reckoning.

However, as Herb Stein famously said, "If something cannot go on forever, it will stop."