Businesses and investors like certainty, and there’s been a distinct lack of it lately. That, above all else, may have driven the weak business investment that we’ve seen in recent years. And while other factors that influence investment are relatively easy to control, uncertainty is a little more intangible.
We can expect continued reticence by business to invest via financing in the near term, says ICAEW’s Head of Financial Services, Reuben Wales.
“If you’re a small business, you want to invest and you're thinking about doing that via financing, you're currently in a situation where your cost inputs (in particular energy and supply-chain costs) are relatively unpredictable,” he says. “The inflationary pressures that you're probably seeing mean that you're not necessarily clear on what your cost base might be from one year to the next. Equally, if you are going to borrow to invest, you're quite unsure at this point as to what that financing cost might look like.”
Interest rates have been relatively consistent for at least a decade, which has given businesses a clear picture of what a business loan, for instance, might cost them. Now, with interest rates rising and the possibility of further, more significant increases in the future, SMEs – which have very little bargaining power when it comes to interest rates – do not know what financing might cost them year to year. It is materially higher now than it was this time last year, and it could be materially higher still in a year’s time.
“It's going to come back to risk appetite and what your returns might be if you do invest, which are also informed by the potential for depressed demand whether due to lack of confidence or the financial pressures faced by the business's customers. Irrespectively, it is going to deter a number of businesses from making large investments,” says Wales.
On the other side of the coin, banks are weighing up similar issues. They want to know that businesses are going to be able to service the interest and principle commitments required of the loan. If they can’t be sure of what a business’s cost base might look like in 12 months’ time, and the extent to which it might be able to pass on cost increases to customers in revenue generation, they’re less likely to approve a loan. “When the finance provider is undergoing an affordability assessment on a firm for credit risk, there's a number of unknowns, which mean they themselves will also have to take a view on where their risk appetite lies,” says Wales.
During recessions, high street retail banks tend to retrench and focus on a prime customer base – typically, established businesses with healthy and defendable positive operating cash flows. It then becomes incumbent on smaller finance providers that may have a bigger appetite for risk to fill the space. We may see that happening again. However, it is also likely that these businesses, if they can access this financing, will face more significant increases in funding costs and fee charges due to their heightened credit risk, which would put further financial pressure on them.
But even with that credit lifeline, a number of SMEs are already sitting with a level of debt post-COVID, having taken on loans to get through that period including government-backed lending schemes. It may not be clear how those debts will be repaid as day-to-day costs increase, nor the appetite of finance providers to offer refinancing. Consequently, scale and challenger finance providers are faced with a different credit risk prospect than in previous crises.
While increasing interest rates may seem counterintuitive to some in this environment, the Bank of England remains deeply concerned over persistently high inflation, which is already impacting on the overall cost base of the vast majority of businesses.
“If you're raising interest rates, that obviously has an immediate impact on any size business that has outstanding debt linked to a variable rate,” says Wales. “But the theory is that inflationary increases in a business’s cost base are much more impactful at the moment (c. 10% overall cost base) than, say, the prospect of higher financing costs. If we can provide more certainty around price stability, then perhaps the additional financing cost is a price worth paying.”
The Energy Bill Relief Scheme will provide some support in the short term, which is welcome, but at the same time, businesses need that certainty over a longer period of time than six months. Until we get a clearer vision of the next three to five years, we’re unlikely to see a big uptick in business investment, says Wales.
“Stability, certainly – those are things that point to the future. We need to look at what businesses need going forward as well as what they need right now. The clearer we can be about what’s ahead, the more we can get businesses to take a managed risk and invest.”
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