Higher-for-Longer Interest Rate Environment is Squeezing More Borrowers

Central Banks Navigate Unprecedented Interest Rate Hikes

The world’s central banks have embarked on an extraordinary journey, implementing some of the most substantial interest rate increases in decades over the past two years. Their primary objective? To curb the rampant inflation sweeping across economies. Since late 2021, policymakers have collectively raised rates by an average of 400 basis points in advanced economies and approximately 650 basis points in emerging market economies.

While most economies have admirably weathered this robust policy tightening, showcasing resilience in the past year, core inflation continues to linger at elevated levels in several regions, notably the United States and certain parts of Europe. Consequently, major central banks may find themselves in the unenviable position of having to maintain higher interest rates for an extended period.

In this economic landscape, potential risks loom large, as discussed in detail in our latest Global Financial Stability Report. Although the vulnerabilities highlighted in this assessment echo our earlier findings from April, a marked reduction in stress within certain banking systems has been observed. However, new indications of challenges are surfacing elsewhere, warranting a closer examination.

One such alarming signal is the diminishing capacity of individual and business borrowers to meet their debt obligations, commonly referred to as credit risk. The deliberate consequence of raising interest rates as a part of monetary policy tightening to combat inflation is to make debt more costly. However, the downside risk lies in the precarious financial positions that borrowers might already be in, coupled with the potential amplification of these vulnerabilities as a result of higher interest rates, leading to an upsurge in defaults.

Eroding Financial Reserves

In the corporate realm, numerous businesses grappled with closures during the pandemic, while others managed to accumulate substantial cash reserves, partly due to fiscal support across various countries. Additionally, firms were able to protect their profit margins, even as inflation surged. However, in a world of prolonged high interest rates, many businesses are now depleting their cash buffers. This is due to a moderation in earnings and escalating costs associated with servicing their debt.

Remarkably, the Global Financial Stability Report (GFSR) reveals an increasing proportion of small and mid-sized businesses in both advanced and emerging market economies. These businesses barely have sufficient cash to cover their interest expenses. Troublingly, defaults are on the rise within the leveraged loan market, a domain where financially weaker firms seek funding. This challenge is poised to intensify in the coming year as more than $5.5 trillion of corporate debt approaches maturity.

Households, too, have been tapping into their financial reserves. Excess savings in advanced economies have steadily diminished from their peak levels in the early part of last year, which were equivalent to 4% to 8% of gross domestic product. Disturbingly, signs of mounting delinquencies in credit cards and auto loans are surfacing.

The real estate sector is not immune to these headwinds either. Home mortgages, which typically constitute the largest segment of household borrowing, now bear substantially higher interest rates compared to just a year ago. This trend is eroding savings and placing pressure on housing markets. Regions with predominantly variable-rate mortgages are experiencing more pronounced declines in home prices. Higher interest rates are translating into mortgage payment difficulties more quickly. In the commercial real estate arena, a similar strain is evident. Elevated interest rates have resulted in the drying up of funding sources, slowing down transactions, and contributing to the surge in defaults.

Challenges Extend to Governments

Governments are not exempt from the challenges of higher interest rates. Frontier and low-income countries are grappling with increasing difficulties in borrowing hard currencies like the euro, yen, US dollar, and UK pound, as foreign investors demand higher returns. This year, hard currency bond issuances have occurred at significantly higher coupon rates or interest rates. It is crucial to note that concerns about sovereign debt extend beyond low-income countries. The recent upsurge in longer-term interest rates in advanced economies has vividly illustrated this.

Major emerging economies, on the other hand, are relatively shielded from this predicament, thanks to their more robust economic fundamentals and financial health. Nonetheless, the flow of foreign portfolio investment into these nations has also decelerated. China, in particular, has witnessed the exodus of substantial foreign investment in recent months, attributed to the mounting challenges in its property sector, which have shaken investor confidence.

Investor Optimism and Ominous Challenges

Curiously, the majority of investors appear unperturbed by the mounting evidence of borrowers struggling to meet their repayment obligations. Investors, alongside generally robust stock and bond markets, are operating in an environment of eased financial conditions. This outlook is rooted in an optimistic belief in a global soft landing scenario, where higher central bank interest rates effectively control inflation without triggering a recession.

However, this optimism begets two significant problems. Firstly, persistently easy financial conditions could continue to fuel inflation. Secondly, these rates could tighten abruptly in the event of adverse shocks, such as an escalation of the conflict in Ukraine or a deepening crisis in the Chinese property market.

A rapid tightening of financial conditions places additional strain on already vulnerable banks, particularly those confronted with heightened credit risks. Surveys from various countries already indicate a slowdown in bank lending