For the past 20 years, the major central banks and economic policy-makers have prioritised economic growth and preventing recession, and the principal tactic has been to lower interest rates. This has been the reaction to every major economic or geopolitical shock since 2001.
At the beginning of the century, the dotcom crash and the 9/11 terrorist attacks in the US prompted this response. The banking crisis of 2008, which featured major insolvencies and state bailouts of large western banks, prompted interest rates to be set at near-zero. More recently the Covid pandemic and associated economic downturn in 2020-2021 sent interests from low to ultra-low.
Over a period of more than 20 years, interest rates have been low by historic standards, and for much of the past 15 years they have been ultra-low. Anyone in the working world under the age of around 40-45 has no experience of high interest rates or, with the exception of a few countries, high inflation. In the period 2005-08, the Federal interest rates were between 4% and 5.2%, but for the rest of the past 20 years they have been below 4%, and at times just above zero. By contrast, the rate was at times into double figures in the 1980s and in the range 5-6% for much of the 1990s.
In 2022, the situation changed. The conflict in Ukraine which began in February 2022, and associated global squeeze on energy supplies during a time of economic recovery after Covid, amid other factors, caused inflation to surge, rising above 10% in many economies, the highest rates for decades. Central banks raised interest rates from near-zero to around 4.75% in the space of a few months.
This is beginning to have a major impact in the real economy. Arguably, the normalisation of rates is necessary, might have begun earlier, and will have positive effects. Ultra-cheap money has encouraged high leverage and speculation, for example the much-publicised bubble in crypto currency valuations. The rise in bond yields following interest rate rises helps rebalance investment portfolios to include a higher proportion of safe assets. Yields are still typically lower than the inflation rate, but they often were in the low inflation era, as interest rates were so low.
Higher interest rates will cause some highly leveraged businesses and risky investment strategies to fail. Increased rates will deter excessive debt and speculation, and of course they reward savers. The combination should help direct investment towards activities that are safer and sustainable.
The nations of the Gulf Co-operation Council (GCC) are not isolated from this trend. GCC central banks had to follow the lead set by major central banks and increase rates, which meant many sectors of the economy that borrowed heavily are now exposed to a higher cost of interest. This will affect cashflows and the ability of indebted firms to pay debt, dividends and their future investments plans.
In my opinion, real estate will be one of the most vulnerable sectors, followed by contracting sector and overleveraged family conglomerates. They may face a more difficult trading environment as well as higher rates, causing a cash squeeze. It is likely that some firms will become insolvent, with potentially a significant impact on the wider economy, depending on the scale. These effects could be minimised with some amendments to bankruptcy procedures. When setting such regulations, there is a balance to be struck between protecting lenders’ interests without being too strict towards honest businesspeople who have set up a business and run into genuine trading difficulties. An overly punitive system towards business founders would deter entrepreneurs, but it is reasonable to ensure that those who lent capital can minimise their losses in a timely fashion. As things stand, for example with foreclosures, the process of securing and selling the asset against which the money was lent can take up to three or four years due to the current legal procedures. This can deter banks from lending to promising enterprises.
How long the period of higher interest rates will last is difficult to call, given an unpredictable geopolitical situation. It is possible that inflation has peaked, and that interest rates are close to their highest point, but of course unforeseeable events could cause that to change once again. In early 2023, inflation has begun to dip, helped by lower energy prices, caused in part by a relatively mild winter in Europe, and rapid shifts in supply. We have seen improvements in the energy sector’s supply chain, which may lead to oversupply due to the considerable investment in the past three years, which could add to downward pressure on prices.
There isn’t a lack of investment capital in today’s global economy. Banks are willing to lend, but at a higher interest rate. This means higher debt servicing costs, but also, most probably, a more sensible allocation of capital with better long-term returns.
The author is a Qatari banker, with many years of experience in the banking sector in senior positions.
