What is behind the interest rate turnaround?

In June 2022, the key interest rate set by the European Central Bank (ECB) was still 0 percent — since then, there has been a wave of previously unknown increases. The latest of the seven interest rate rises so far occurred in May 2023, when the ECB raised the key interest rate by a further 0.25 percentage points to 3.75 percent. At the same time, the Bank of England also raised its base rate by 0.25 percent, to 4.5 percent. And, according to many experts, this trend is not yet over: at least one further interest rate rise is expected in the not too distant future.

The reason for this interest rate turnaround is as follows: increasing the key interest rate is intended to curb inflation, which has been well above the 2.0 percent target set by the ECB since the war in Ukraine started. In October 2022, the price increase was 10.4 percent; in April 2023, the inflation rate levelled off at 7.2 percent.

The principle behind this strategy is simple: increasing the key interest rate makes it more expensive for commercial banks to borrow money, resulting in a shortage in the supply of money. Financial institutions pass on the cost increase to consumers and companies. As a result, loans become more expensive for companies, so they borrow less and invest less.

On the other hand, the savings rate is rising as investments pay higher interest rates again. This slows down overall economic demand — and therefore usually also the rise in prices, as supply and demand change and result in a new - and in this case lower - price.


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The disadvantages of raising interest rates

However, the sharp rise in the key interest rate in record time poses some risks for companies. As previously mentioned, overall economic demand is falling — and that could pose a problem for companies which already have a low credit rating.

As early as 2022, the number of corporate insolvencies in Europe had in some cases risen significantly. And figures from March 2023 showed that UK corporate insolvencies have risen 16 percent year-on-year  and 38 percent since February 2023. Ernst & Young’s latest Profit Warnings report found that warnings from UK-listed companies in the first quarter of 2023 reached their highest first quarter total since the start of the COVID-19 pandemic.

And experience has shown that interest rate rises also initially have a negative effect on the share prices of listed companies: when interest rates rise, stocks lose their appeal as an investment in comparison to a savings investment. In addition, financing equity investments is becoming more expensive.

The interest rate rise is also affecting companies' balance sheets. Interest rates increase the risk of value adjustments. As a result, the value of goodwill could fall.

For small- and medium-sized companies, higher interest rates can lead to lower demand, with customers being more reluctant to shop on credit. This is especially true in the current cost of living crisis, with a growing number of consumers already in debt. The UK has the sixth highest household debt to GDP ratio of any G20 nation: in March 2022, Britons had an average personal debt of £33,410 — greater than the average annual income. According to Deloitte, while there are encouraging signs of consumer confidence in 2023, this is not reflected in consumer spending. As food and energy bills continue to rise, consumers are cutting down their non-essential net spending, with discretionary spending falling for the fifth consecutive quarter, down one percentage point to -10.6%.

How can companies react to the current key interest rate?

The further course of interest rate developments will be decisive. Experts believe that a moderate increase is likely, but the peak will be reached at some point — at the latest, when inflation falls significantly or the economy collapses more than feared. Professional interest rate management is therefore likely to be of crucial importance for companies. Anyone who wants or needs to borrow now can, for example, try to secure loans with variable interest rates. Financing instruments such as derivatives or public funding programmes can also help cushion interest rate rises.

An alternative to further credit financing is to strengthen the equity ratio. Equity financing can be an option for some companies. For small- to medium-sized companies, this can range from selling parts of their business to family and friends, to attracting investment from private equity firms and angel investors, or even crowdfunding. There are a number of options available for small- to medium-sized companies in the UK — but of course, it’s crucial to get independent financial advice beforehand.