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CEO Circle

Higher borrowing costs call for financial prudence 

Published 23 February 2022 in CEO Circle • 3 min read

As the era of ultra-loose monetary policy ends imminently, corporates will need to act wisely and carefully to navigate a treacherous landscape. 

 

With inflation raging at near or above multi-year peaks, major central banks are signaling unmistakably that higher interest rates are on the way. In some major economies, monetary policy has already tightened. 

The US Federal Reserve is widely expected to make its first hike in March with more thereafter, following hawkish comments from Chair Jay Powell at the central bank’s last meeting in January. The Bank of England increased the cost of borrowing from 0.25% to 0.5% in February. Christine Lagarde, the European Central Bank’s president, is talking down rate rises, amid fears about the impact on shakier sovereign borrowers like Italy and Greece. But financial markets have priced in an interest rate rise in June. 

The repercussions for corporates are likely to be very significant, as the cost of borrowing rises across the economy, calling for financial prudence. 

The era of ultra-loose monetary policy prompted a surge in corporate borrowing. Some has been to finance and accelerate growth and investment, whether in a productive capacity or research and development. But ultra-cheap money has spurred some questionable developments. 

 

Rethinking M&A valuation 

Mergers and acquisitions have flourished, pointing to higher levels of risk-taking as boardrooms regained their animal spirits after the initial pandemic shock had subsided. And with historically high asset valuations, pushed up by competition, there is a risk that acquisitive companies are overpaying for their targets. 

The message for CEOs is clear: be willing to walk away from targets with sky-high multiples. Do not let your egos or desire for empire-building cloud your judgment. Data shows that M&A deals are often only beneficial for the target. In times like these, with increasing debt costs and sky-high valuations, the downside risks for acquirers are magnified. That’s why CFOs facing significantly higher costs of capital are likely to set much higher hurdles for investments and acquisitions, tweaking their models to ensure adequate returns. 

Airbus and Boeing are already having to financially support a crucial supplier, so some future degree of greater vertical integration across the value chain may be inevitable

The case against share buybacks 

Another offspring of the cheap money era has been the habit of many companies – often under pressure from activist investors – to leverage their balance sheets and take up debt to repurchase their own shares. 

With the stock market still near past highs, companies risk overpaying for their own shares. The other risk is that buybacks reduce real investment and even lead to financial fragility, because as interest rates rise, companies could struggle to meet their higher borrowing and refinancing costs. Many will also want to raise money on the bond market and lock in low borrowing costs now, before rates start to climb any higher. 

 

Value chains need supplier support 

More immediate, though, are the risks to supply chains. The combination of higher demand fueled by cheap money and the dislocation caused by COVID-19 has played havoc with many companies and caused certain product shortages. 

But just imagine a scenario where key suppliers of, say, leading manufacturers of planes, trains or automobiles, found themselves in financial difficulties. Examples already abound of companies such as Airbus and Boeing having to financially support a crucial supplier. Some future degree of greater vertical integration across the value chain may be inevitable. 

Make sure you are sufficiently aware of, and adequately understand, the financial situations of your key suppliers. If you have any cause for concern, reach out and, if necessary, make a proposal to ease the strains. The risks of serious disruption caused by failing to act will far outweigh any short-term costs. 

 

The price is right 

Much more worrying still are the potential macroeconomic repercussions of higher rates of interest. Consumer confidence has fallen because of rising living costs, inflation and higher borrowing costs, which is slowing down the pace of the economic recovery. 

People do not think now is the right time to make major purchases, which hits sellers and poses a particular challenge for firms that built up inventories to cope with supply chain bottlenecks. The supply squeeze has enabled corporates to pass on rising costs to consumers, but a slowdown in consumer confidence undermines price rises. So discounting may be inevitable. 

Against this treacherous background, I have great sympathy for central bankers facing the challenge of bringing inflation under control while avoiding the risks of over-tightening: disrupting growth and markets. 

For CEOs, that could make 2022 the hardest year of the pandemic yet to navigate. But while they may be increasing the probability of worst-case outcomes in their scenario-planning, they can put in place measures now to control higher costs and put their organization on a sound financial footing. 

Authors

Karl Schmedders - IMD Professor of Finance

Karl Schmedders

Professor of Finance at IMD

Karl Schmedders is Professor of Finance at IMD. In his research, he applies numerical solution techniques to complex economic and financial models, shedding light on relevant market issues and industry problems. He is also Director of IMD’s new online certification course for structured investment products in partnership with Swiss company Leonteq, teaches in the Advanced Management Concepts (AMC) and Executive MBA programs, and is an advisor on International Consulting Projects in the MBA program.

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