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Inflation and interest rates – this time it’s different

David Hudson, Restructuring & Recovery partner at Baker Tilly
The recent announcement of the 5.2% CPI inflation rate for September is another indicator that interest rates may soon start to rise in the UK, putting an even tighter squeeze on business. Many businesses are therefore facing dangers that are largely beyond their control.

It is likely there will be an increase in insolvencies over the next 12 months. Businesses find themselves faced with rising costs, which they cannot necessarily pass on to their customers while their cost of finance is set to rise.david hudson

What is different this time, compared with previous recessions, is that these inflation levels are beyond the control of the Bank of England or UK government. They are being driven by global pressures. September figures showed China’s inflation rise to 6.1% and 3% across the Eurozone. India’s was a staggering 9% in August. Across the Atlantic, the current 3.8% figure for August shows an increase from the 2.7% quoted in March. All of this will have a ripple effect down to the majority of UK businesses in some form.

If the Bank of England was to raise interest rates tomorrow, it will have little or no effect on the prices of the commodities that are pushing up input costs for businesses.

In the UK, the average price of diesel is now around £1.40 a litre. The 1% cut in fuel duty in the Chancellor’s 23 March budget has not made much of a difference, especially as VAT rose 2.5% at the turn of the year. This in turn impacts every business that relies upon deliveries of materials or goods from suppliers or itself transports its goods to customers. The result is a stark catch-22; either increase prices and risk a drop in sales or maintain prices and accept the margins will be squeezed.

But the price of oil is only one issue to contend with. At the time of going to print, the prices of key commodities – including corn, hops, cotton, sugar, gas, meat, copper, steel and gold – are all higher than last year. Therefore, very few businesses are unaffected. Those worst hit, as a result of high fuel prices, are likely to include transport operators or those businesses dependent on large road distribution networks. Yet the impact will be seen right the way down to cottage industries relying on ingredients for their food produce. Inflation is being driven by essential items, fuel, food and clothing. It is not as if businesses and consumers can simply spend less on food and fuel.

 Interest rate rise looming?
Several commentators expect an interest rate rise is imminent with further increases to follow later in 2011. Inevitably these rate rises will be passed on to corporate borrowers, most of whose loans are priced in relation to London Interbank Offered Rate (LIBOR). Each turn of the interest rate screw will make life increasingly uncomfortable for businesses who find themselves caught in the crossfire between inflation and interest rate rises, neither of which they can duck.

At the moment, there are many businesses and indeed individuals who have extremely high borrowing. Any small interest rate rise will have a significant effect on the economy.

There have been relatively low levels of corporate insolvency over the last 12 months. But there are many companies out there for which a rise in interest rates will be the final straw.

While some businesses that have survived the recession are tough and in good shape to move forward, many are just hanging on. They’ve used up the cash reserves desperately needed to survive. They may be benefiting from interest only arrangements with their banks or be in Time To Pay (TTP) agreements with HMRC, both of which they may or may not be adhering to… Rises in interest rates will particularly impact those companies, forcing some over the edge.

What is to be done?
Against this background, increasing inflation and the prospect of interest rate rises should ring alarm bells with corporate directors, their banks and their professional advisors. Business managers have to take action, but what can they do?

Doing nothing is not an option while margins are being squeezed. They need to take action to maintain profitability, even if it means doing so at the expense of increasing turnover. This may mean putting up prices. It may mean recalibrating their cost base, perhaps for a second (or even a third) time since the onset of the recession. They also need to demonstrate to their lenders that they are taking proactive steps for the good of their businesses. This may mean speaking to their lenders to revisit the terms on which facility repayments are made and discussing rescheduling them. Banks may need to be flexible. Indeed, where loans are being serviced, whether on an interest-only basis or in line with repayment schedules, it would seem to be in the interest of lenders to keep the ball rolling rather than accelerate the pressure on such businesses.

Opportunities for some
There may, however, be some winners from the current situation. Those businesses with commercial strength, such as those that dominate their market niches, will be better able to pass on price rises. To a large extent, maintaining their margins and preserving their working capital requirements will be easier for them. Those in more competitive sectors where raising prices is more difficult to achieve will not be as fortunate, at least in the short term.

There will be businesses that have paid down their debt and are holding substantial cash balances that will now be well placed to make strategic or bolt-on acquisitions – sometimes of distressed competitors.

Transactions are being done with the support of venture capital or private equity. Since the recession, vendors’ price expectations have realigned and this plays into the hands of those acquirers with cash to spend. At the same time, several already distressed businesses are likely to become even more so. Some banks may say, ‘enough is enough’. This in turn may result in acquisition opportunities of businesses out of insolvency.

While it is easy to look back on the worst effects of this particular recession, inflation looks well beyond the control of Bank of England’s traditional interest rate lever. Together, higher inflation and interest rates look set to place many businesses under considerable pressure.