The impact of interest rates and inflation – how can businesses navigate these challenges? | ECA

The impact of interest rates and inflation – how can businesses navigate these challenges? | ECA

Rob Driscoll, ECA Director of Legal & Business, considers the impact of interest rates and inflation and how businesses can remain resilient in an economy that is struggling to right itself.

As Winston Churchill once put it: “The further back you can look, the further forward you are likely to see”. Interest rates and inflation are currently presenting our industry with huge challenges but, for those who choose to take a long-term perspective, what’s currently happening may be more of a national readjustment towards a more realistic price for borrowing money.

The financial crash, which became apparent with Northern Rock in 2007, exposed the volume of lending by the financial sector to borrowers who simply could not afford the rates or the risk (the subprime crisis). Pumping customer debt drove wholesale, untenable risk into consumers, housing, and banking and then into wider businesses. The fix deployed to stop the UK economy from going bankrupt was quantitative easing – a method of keeping interest rates negligibly low.

I’d go as far as to suggest that my generation has never really known the true cost of borrowing money. Most current estimates predict that interest rates will peak at around 5.5% over the next two years.

That’s quite a shock compared to even a few years ago, but still low if compared to the 15% or so interest rates in the early 1980s. Indeed, the total cost of servicing debt in the UK today is double the percentage of the 1980s, even though today’s interest rates are still only a third of those experienced back then.

As interest rates continue to rise, a worry is that the ‘free money’ generation will struggle to service the cost of this debt. And if customers default in sufficient numbers, lenders will be at significant risk (noting that Silicon Valley Bank and Credit Suisse only recently managed to spook the markets).

But even if the rising cost of borrowing can be viewed as a correction to some bygone business as usual, we will still feel economic turbulence ahead, simply because money has been so remarkably cheap for so long.

Disproportionate inflation

Alongside interest rates, of course, lies inflation. The recent high rate of inflation was fuelled by supply-side pressures from global energy and metal prices and demand-led inflation due to a post-Covid mini boom (specifically in private housing and housing improvement), which interest rates and inflation have now quashed.

In 2022 the electrical sector endured materials inflation at more than 23%, in addition to wage inflation. Current inflation rates remain daunting and while the rate of increase is expected to fall this year, most of the increases we’ve already seen remain locked into material prices. In addition, UK inflation is still significantly higher than in Western Europe and the US.

Impact on public procurement

The government is feeling the impact of all this too, in the form of growing interest charges for national debt (mainly due to Covid borrowing costs) and less buying power. Even a slight increase in interest rates will take the cost of national repayments to double the national GDP. And all this greatly affects public sector procurement. If the average public project duration is 18 months, given Covid borrowing impacts and inflation, the government and others will struggle to deliver their post-Covid projects on budget. As a result, I anticipate that over the next year, we will see the public sector re-evaluate budgets and plans to accommodate around a 10% inflation-led reduction in budgetary buying power.

Procured activity might also swing from construction to maintenance as the public sector ‘sweats the assets’ and maintains existing buildings. Given the impending election in 2025 at the latest, it’s less likely that projects will be cancelled altogether, but it isn’t out of the question that some will be ‘rescheduled’ (put on hold).

It’s usually held that, in economic downturns, construction lags 12 to 18 months behind the mainstream economy, as contracts are already in place on fixed prices. This can buy time enough to see the biggest business storms coming but in this inflationary period, we are already witnessing dangerously increasing levels of insolvencies in construction.

However, even this traditional lag may be affected because, historically, commercial/industrial was the largest sector of construction. Now, it is private house building, followed closely by private housing repair, maintenance and improvement, so the impact of rising interest rates and inflation on our sector may be sooner. Moreover, housebuilding has fallen by 30% to 40% as many potential new buyers aim to sit out higher mortgage costs.

In search of resilience

In the meantime, ECA reminds businesses that resilience and informed risk are key to navigating these considerable challenges. If the one business constant is ongoing change, then spreading risk and being ready to pivot may be essential.

ECA maintains sources of helpful information, including links to the Construction Leadership Council Product Availability Group Statements on inflation, guidance on adjusting contracts for inflation and templates to help strengthen a risk profile. Pointing clients to a third-party source can also help them understand the problems and reach a mutually beneficial agreement.

If a business can stay away from fixed lump-sum pricing, it will be in a much better position to avoid losses due to inflation during a project. For example, it could be a good idea to aim for a provisional sum so that a notional budget price is included, and only certain cost elements fluctuate.

Also, don’t forget to check on potential customers before considering contractual arrangements. In the financial crash, bank lending fell by 5% generally but by 38% in construction. When banks are reluctant to lend money, buyers can view their supply chain as a source of free finance. We saw this in the 2008 financial crash when extended payment periods tripled.

Do your due diligence

It’s vital to avoid being someone else’s overdraft, so due diligence and credit control are vital. It may seem obvious, but credit checks are cost-effective and it’s simple to look on the government website for a buyer’s payment record. Word of mouth is also a valuable source of information – when it comes to doing business, we’re all only as good as our reputation. Riding out the next 18 months means pricing long-term projects carefully and being strict about on-time payments.

Despite these sustained business challenges, potential growth areas still exist, particularly in private housing repair, maintenance and improvement and energy management. If sweating the assets is economically counter cyclical, this sector is expected to grow by around 4% in 2024 as homeowners who aren’t selling look to improve their properties. We also see greater interest in domestic EV charging and solar panel installation, which are not only present, but also future business opportunities.

The overall message for the rest of 2023 and 2024 is that we can expect even more turbulence, but if we can weather the current storms and pursue opportunities, the business environment in 2025 might just be that much brighter.

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