Benel D. Lagua l October 5, 2022 l Manila Bulletin
When interest rates were down as during the President Benigo S. Aquino administration, businesses were incentivized to borrow more. Debt after all is the juice that will allow firms to invest for growth, expansion and innovation. In the modern financial system, savers with excess cash are able to channel funds to borrowers through the intermediation process. If this process is done efficiently, both borrowers and savers are appropriately rewarded and the economy as a whole benefits.
My generation’s favorite cartoon during our young days was “Popeye, The Sailor”. A popular character in the series was Wimpy who smilingly promises, “I’ll gladly pay you Tuesday for a hamburger today.” Wimpy’s Tuesday apparently never comes and this classic cartoon line is commonly used to illustrate financial irresponsibility. Nonetheless it illustrates how credit allows satisfaction of needs and how leverage leads to prosperity, or a full Wimpy.
Getting financing from debt is appropriately termed leverage. Recall that in physics leverage is the execution of force by means of a lever or rigid bar that pivots about one point to allow the lifting of heavier weight. Likewise financial leverage is using borrowed money to control assets owners couldn’t control otherwise and multiply the potential return from a project.
As financial analysts reckon, the cost of credit must be below the basic earning power of the firm. Keeping the cost low will translate to the margin providing additional earnings to the stockholders. Return on equity is thus improved with credit expansion.
Today, however, the interest rate regime has shifted. With the unchecked inflation in the US, the Federal Reserve has been steadily increasing its policy rates as a monetary policy reaction. This move is creating huge ripples across the globe as the US dollar strengthens. With little recourse, central banks have been raising interest rates. One news report says that at least 89 economies around the world have increased their rates.
The Bangko Sentral ng Pilipinas has raised the policy rate from a low 2.0% in March 2022 to 4.25% as of this writing and is expected by analysts to raise this to 5.0% by the end of the year. The peso has already sharply dropped against the US dollar because of the US Fed’s hike and tightening approach. And with no end to the mighty dollar apparently in sight, interest rates are likely on an upward trajectory in an effort to anchor inflation, arrest the depreciation, and curtail capital flight.
Big companies with steady sources of cash flow will be resilient to the expected rise in borrowing costs. Note that the past two years also saw the growth of borrowing by the conglomerates in the bond market. The move allowed these firms to lock in debts at low fixed rates. But there will be a sector of the economy, particularly SMEs whose operating profits were already disturbed by the pandemic of the past two years, that could face further troubles ahead. These corporates, more likely exposed to floating and adjustable interest rates, will bear the brunt of upward rate adjustments.
If the soaring interest rates is followed by higher operating cost, lower market demand and reduced earning, many firms will move into turbulent territory. Will they be able to manage their bottom lines and survive?
Even prior to the interest rates concern, SMEs are already facing access to finance problems. First, SMEs are considered opaque firms that are very difficult to assess due to limited verifiable information. Secondly, there is an incentive issue especially in the formal banking sector where rewards to account officers are normally tilted towards big loans and the returns/profits generated from such lending efforts. Finally, high transaction cost argument refers to the same cost and effort necessary to process a small vs. a large loan application leading to credit rationing.
While returns can be magnified because of leverage, it can also move in the opposite direction. Firms can see accelerated destruction when earnings from operations cannot cope with interest payments. In cases of negative profitability, leverage increases the magnitude of losses. Companies in these areas have high business risk, and financial risk from debt aggravates their situation.
When the weather bureau raises the storm signals, disaster preparedness like evacuation measure is put in place to prevent losses. Disaster preparation requires study and development of a crisis action plan. It includes drills and in-depth reviews long before the actual storm.
But in this economic storm that we all see in the short run, are there contingency measures the projected victims can take? It all starts with a careful assessment to develop a strategic approach. The company must review its circumstance, check the revenue streams, look at risk areas, manage control systems, and study possible pivot moves and mitigants. Take ownership of the problem as it will not disappear by itself. Know the numbers and start with a sharpened pencil, so to speak.
There are no easy solutions but starting off with a clear awareness of the situation is a step in the right path. To survive, concrete action plans must be identified even before the problem finally arrives. Only the pro-active will hurdle this brewing credit storm.
*** (Benel Dela Paz Lagua was previously EVP and Chief Development Officer at the Development Bank of the Philippines. He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.)