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The policy rate and small businesses

EVERYDAY, we receive newspaper, television, radio and online platform reports on changing policy interest rates, both local and abroad. A typical report is the Bangko Sentral ng Pilipinas (BSP) raising the key policy rate in September by another 50 basis points (100 basis points or bps equals 1%) to 4.25%.  Analysts expect another 50-bp hike in November and a 25-bp hike in December, bringing the policy rate to 5% by yearend.  In the US, the current Federal Reserve interest rate is 3% to 3.25%, and it is projected to be raised by 125 bps, bringing the rate to 4.25% to 4.5% before 2022 ends.

How important are these policy rates?  It impacts everything, from the rate we earn on our savings account to the rate we pay for loans. Deposit money in banks provide the capital needed for extending loans or credit to customers. Regulators like the Fed in the US and our BSP require that banks keep a certain percentage of capital in reserve as a safeguard for stability and solvency. Banks also borrow money from each other to meet the reserve requirement. These rates serve as the reference for institutions as they are borrowing or lending reserves.

The Fed and our BSP take action to influence money supply as part of their monetary policy toolkit. An expansionary monetary policy, for example, will lower interest rates and thereby stimulate investment and consumption demand in the short run. These days, however, the key concern of regulators is rising inflation, which in the US has been hovering at the 8.3% to 8.5% mark. The Fed has therefore been increasing the policy rate, which will raise short-term borrowing costs, reduce the supply of credit and make loans more expensive. The end objective is to combat inflation.

With inflation headwinds now worldwide, affected by the Ukraine war and other global disruptions, the Philippines is not spared. Combined with local issues like our widening trade deficit, the country must somehow track the policy moves of the US. Already, the peso has depreciated so much that any inaction by our regulators will lead to capital flight and further drops in the currency. Observers believe the BSP has been supporting the local currency, even as some economists argue it cannot do so on a sustained basis.

As the Fed and our BSP move these rates, the rate banks charge each other ripples through the rate charged to customers, both depositors and borrowers.  The prime rate, for example, is what banks charge to large, corporate customers with substantial financial resources. Once the policy rates are adjusted, the prime rate (which is the policy rate plus a premium) will follow suit, and so will the other lending products in the same direction. It sets the baseline for a variety of bank products.

Interest rates represent a promised rate of return and there are so many interest rates as there are borrowing and lending products. The policy rate serves as the starting point for all types of interest rate setting -— mortgage rate for housing loans, commercial loan rates for businesses, personal loan rates, credit card rates, among others.

Banks are rational business entities that need to account for the risks. Once the banks factor in the policy rate, it will adjust the prime rate and many of its other lending products. The adjustments will represent the banks’ perception of different risk premiums. Banks will factor in an inflation premium based on its expectations. The risks that a borrower will default will be considered.  Banks will assess the liquidity of the assets of the potential borrower’s source of repayment. They are also concerned about capital loss exposure because of the changing interest rates and the maturity of the loan.

Bottom line, the regular and ordinary consumers will bear the brunt of the projected upward movements of interest rates. Remember that the prime rate is reserved for the big and the affluent. Small businesses are thus in for a tough ride.

The prospects of the firm are tied to the direction of the broader economy and the policy rate is an important determinant. Firms must keep the big picture in mind as they navigate prospects for growth and at worse, for survival. Being prepared, hopefully the firm can study how it can maneuver, pivot, and adjust its path through an expected more expensive future. But as one expert correctly observed, even in the troughs of business cycles, there are opportunities to be tapped.

Small businesses must keep a close eye on their entire value chain and be prepared for potential disruptions.  There will be strong temptation to apply the all-encompassing cost-cutting tool, but in these days of fine data centric analysis, the scalpel must be strategic, and evidence based.  The firm must develop a good game plan which looks at the important business segments, limiting risks where it can stand mitigation. It must understand its capital structure. At the end of the day, it is better to be ready and  proactive by paying enough attention to the signals of increasing policy rates.

***

The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.

Benel Dela Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines.  He is an active FINEX member and an advocate of risk-based lending for SMEs.  Today, he is independent director in progressive banks and in some NGOs.

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