Tighter monetary policies by central banks around the world to keep inflation in check have exposed the vulnerabilities of some banks. Central banks seem in no mood to reduce interest rates, which has put bankers on their toes to enhance their regulatory responses.
It has become pricey to borrow money for businesses to run their operations, and for individuals to buy a car or home these days. We may all be aware of why is that - High Interest rates.
Recently nearly all the central banks have increased their interest rates which in turn have increased the rate of borrowing.
Central Banks Rates Hike Around the World
Central banks around the world have hiked interest rates to contain the surge of inflation that came as economies recovered from pandemic shutdowns.
The global inflation is expected to decline from 8.8% in 2022 to 6.6% in 2023 and 4.3% in 2024. Along with that interest rates are expected to fall in coming years — how much is up for debate.
Higher-for-Longer Interest Rate Environment is Squeezing More Borrowers
Central banks worldwide have initiated substantial interest-rate hikes, averaging around 400 basis points in advanced economies and approximately 650 basis points in emerging markets since late 2021. While most economies have absorbed this tightening, core inflation, notably in the US and parts of Europe, remains high.
This may necessitate major central banks to maintain higher interest rates for an extended period. Despite improvements since April, risks persist, particularly regarding credit risk due to increased debt-servicing challenges for individuals and businesses. This consequence of tightening policy to curb inflation may exacerbate financial fragilities, potentially resulting in a surge of defaults.
Risks for Banks
Rising rates are a risk for banks, even though many benefit by collecting higher interest rates from borrowers while keeping deposit rates low. Loan losses may also increase as both consumers and businesses now face higher borrowing costs—especially if they lose jobs or business revenues.
Besides loans, banks also invest in bonds and other debt securities, which lose value when interest rates rise. Banks may be forced to sell these at a loss if faced with sudden deposit withdrawals or other funding pressures. The failure of Silicon Valley Bank was a dramatic example of this bond-loss channel.
Global Growth Risks Amid Elevated Inflation
With core inflation still high and declining only slowly in many advanced economies, central banks may need to keep monetary policy tighter for longer than is currently priced in markets. In emerging market economies, progress on lowering inflation appears to be more advanced, with the benefits of early rate hikes becoming apparent.
However, there are discrepancies across regions. Widening divergence of inflation and economic outlook could mark the beginning of the desynchronization of the global monetary policy
In the corporate world, many businesses suffered closures during the pandemic, and others emerged with healthy cash buffers thanks in part to fiscal support in many countries. Firms were also able to protect their profit margins even though inflation had picked up. In a higher-for-longer world, however, many firms are drawing down cash buffers as earnings moderate and as debt servicing costs rise.
Indeed, the GFSR shows increasing shares of small and mid-sized firms in both advanced and emerging market economies with barely enough cash to pay their interest expenses. And defaults are on the rise in the leveraged loan market, where financially weaker firms borrow. These troubles are likely going to worsen in the coming year as more than $5.5 trillion of corporate debt comes due.
The concern arises from the global economy's readiness to cope with high interest rates after the pandemic. Many countries, especially lower-income ones, have accumulated substantial debts. US banks are strained, some requiring bailouts. The increased borrowing costs will add to the challenges faced by the struggling property sector. Household savings are decreasing globally, and there's a rise in delinquencies on credit cards and auto loans in certain markets. IMF Managing Director Kristalina Georgieva has cautioned about a complex threat to stability during a Forum in Beijing held this year.
Effect on Economy
The world economy is experiencing a slowdown. According to the IMF, global economic growth is projected to be 3% in 2023, down from 3.5% in 2022. As the impact of tighter monetary policies and higher interest rates takes hold, growth is expected to further decrease to 2.9% in 2024.
This is notably lower than the 3.8% average growth seen between 2000 and 2019. In fact, the medium-term growth forecast of 3.1% is the lowest in decades. Additionally, ongoing geopolitical tensions, such as the Israel-Palestine conflict, introduce more risk to global growth.
Despite the overall uncertainty, the IMF has recently raised India's FY24 growth forecast to 6.3%, making it the fastest-growing large economy. However, the scenario of persistently high interest rates has the potential to disrupt this growth. It's already causing bond yields to rise in the US, which may lead to a shift in investment portfolios away from India.
If this occurs, the value of the rupee may decrease. A weaker rupee would lead to higher costs for imports, potentially driving up inflation. In response, the Reserve Bank of India might consider raising interest rates, which could, in turn, slow down economic growth.