High inflation could boost equity financing – EURACTIV.com
As interest rates rise in response to high inflation figures, companies may have an incentive to turn to equity rather than debt to finance their investments. Overall, however, investments could stagnate due to the uncertain economic outlook.
In June, year-on-year inflation reached around 8.6%, according to Eurostat figures, an increase largely due to high energy prices rather than an overheating economy. Anxious to keep inflation expectations at a relatively low level, the European Central Bank (ECB) has announced a normalization of its monetary policy – even if this cannot directly influence energy prices.
A costly debt
With financial markets anticipating this change in policy, interest rates have risen sharply over the past two months.
According to Stephan Bruckbauer, chief economist at UniCredit Austria, rising interest rates mean it now costs companies 2 to 2.5 percentage points more to borrow money.
More importantly, real interest rates also increased by 2.5 percentage points because, while nominal interest rates have risen significantly, long-term inflation expectations remain low.
“Issuing a corporate bond will cost more,” Bruckbauer told EURACTIV. With debt becoming more expensive due to rising real interest rates, European companies may turn to other means of financing themselves.
“The equity share could go up,” Bruckbauer said, adding that it’s also generally more beneficial for investors to hold equity in times of high inflation. However, such a change is not yet visible, he said.
Lower investment growth
European companies tend to rely heavily on debt – mainly bank loans – to finance themselves, while across the Atlantic US companies can more easily resort to equity financing.
This is generally considered to be one of the main reasons why European companies do not grow as fast, nor produce as many disruptive innovations as American companies, because the EU market is not built in a way allow banks to take such risks.
The European Commission has long had the ambition to change this by creating a “Capital Markets Union”. His most recent proposal to lift EU businesses out of their overreliance on bank loans is the introduction of a so-called “debt-to-equity bias reduction allowance (DEBRA) which should encourage companies to finance themselves with more equity instead of debt.
The rising cost of access to finance could also reduce companies’ appetite for financing new investments. However, Bruckbauer argued that financing costs were less relevant to investment decisions than the general economic prospects of companies.
And that outlook has deteriorated in recent months. For example, Eurostat’s business confidence indicator fell significantly in the first half of this year, while the economic uncertainty indicator increased over the same period.
“The pain is there and it has not much to do with funding costs but with rising prices and uncertainty,” Bruckbauer told EURACTIV, adding that he expected growth in lower investments or stagnant investments due to market uncertainty.
What about “green investments”?
Sluggish investment is bad news for the development of the economy in general, but it could also harm the green transition. In 2020, for example, the European Commission estimated that the green transition would require €260 billion of additional investment each year to meet its 2030 climate goals.
Since EU governments are reluctant to mobilize a lot of public money for this, much of the financing will have to come from private funding.
However, Bruckbauer said the nature of the current crisis made green investments more attractive than before. With rising energy prices, the supply of green energy as well as energy saving becomes much more cost effective, making investments in these sectors more attractive. According to UniCredit Austria’s chief economist, this benefit should outweigh the burden of rising funding costs.
[Edited by Nathalie Weatherald]