Believe it or not, there is good news about rising interest rates

Posted on January 25, 2024 by Vauxhall Advance

The era of continuously declining interest rates, which lasted for 40 years, has come to an end.

Businesses and governments now face a new period of higher interest rates. While this shift may initially appear detrimental to economic growth and prosperity, it carries the potential to drive productivity – a critical factor in ensuring that companies can adequately compensate their employees in the face of rising consumer prices, thereby enhancing living standards.

The significance of productivity growth cannot be overstated. Canada’s experience of sluggish productivity growth since 2015 has led to economic stagnation, with current data indicating that the country’s Gross Domestic Product (GDP) is now in recession.

This underscores the importance of fostering productivity, especially as Canada’s capital investment as a per centage of GDP lags behind other Economic Cooperation and Development (OECD) countries, resulting in declining productivity rankings that place the nation at the bottom of the OECD list.

To thrive in this changing landscape, businesses must aim for a return on investment commensurate with the higher capital costs associated with these rising interest rates, typically around 7.4 per cent. Whether raising funds through treasury shares or securing bank loans, the cost varies depending on factors such as debt seniority and creditworthiness.

Historically, short-term interest rates have typically been slightly higher than the current inflation rate, and longer-term rates have included a variable’ term premium’ of at least a few basis points (where a basis point is one one-hundredth of a per centage point) per year for each year to maturity. The period from 1981 to 2021, characterized by consistently falling interest rates with occasional exceptions, was an anomaly unlikely to be repeated.

In the long term, the expected return on investment in a business, often referred to as the ‘earnings yield,’ should equal the cost of capital required for investment. This cost of capital is reflected in financial metrics like the price-earnings ratio. For example, an Exchange Traded Fund based on the Toronto Stock Exchange-S&P60 Index, representing the 60 largest publicly traded companies in Canada, has a P/E ratio of 13.46, corresponding to an earnings yield of 7.4 per cent.

Theoretically, any company undertaking capital spending now should aim for a return of at least 7.4 per cent. If they issue treasury shares to raise funds for a project, the cost would be around 7.4 per cent. Bank loans or bond interest costs for expansion or improvements would vary, ranging from slightly above the government’s cost of just over three per cent for long-term borrowing to 7.4 per cent. The final rate depends on factors like debt seniority and the company’s creditworthiness.

While businesses, particularly in the real estate and construction industries, now face higher capital costs, it’s equally important to consider the quality of projects that move forward rather than just the quantity. Projects undertaken during the era of low interest rates may not now be of sufficient quality to boost productivity and economic growth.

The economic implications of transitioning to higher interest rates are profound. While they may entail more expensive capital, they also compel companies and governments to invest wisely in order to navigate this new reality effectively.

Ultimately, the key to enduring prosperity lies in harnessing productivity to drive economic growth.

Ian Madsen is the Senior Policy Analyst at the Frontier Centre for Public Policy.

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