High inflation could increase equity financing

by Janos Allenbach-Ammann

Since interest rates increase as a reaction to high inflation figures, corporations might be incentivised to turn towards equity instead of debt to finance their investments. Overall, however, investments could stagnate due to the uncertain economic outlook.

In June, year-on-year inflation reached an estimated 8.6%, according to figures from Eurostat, an increase is largely driven by high energy prices instead of an overheated economy. Anxious to keep inflation expectations relatively low, the European Central Bank (ECB) announced a normalisation of its monetary policy – despite this not being able to directly influence energy prices.

Expensive debt

With financial markets anticipating this change of policy, interest rates have risen sharply over the past couple of months.

According to Stephan Bruckbauer, chief economist at UniCredit Austria, the rise in interest rates means that it now costs 2-2.5 percentage points more for companies to borrow money.

More importantly, real interest rates have also moved up by up to 2.5 percentage points because, while nominal interest rates increased substantially, long-term inflation expectations remain low.

“Issuing a corporate bond will be more expensive,” Bruckbauer told EURACTIV. With debt becoming increasingly expensive due to the rise in real interest rates, European companies might look to other ways to finance themselves.

“The share of equity might increase,” Bruckbauer said, adding that it was usually also more advantageous for investors to hold equity in times of high inflation. However, such a shift is not visible yet, he said.

Lower investment growth

European companies tend to largely rely on debt – mostly bank loans – in order to finance themselves, while across the Atlantic US companies can resort to equity finance more easily.

This is generally understood to be one of the main reasons why European companies do not grow as fast, nor produce as many disruptive innovations as US companies since the EU market is not built in a way to allow banks to take such risks.

The EU Commission has long had the ambition to change that by creating a “capital markets union”. Its most recent proposal to ween EU companies off their over-reliance on bank loans is the introduction of a so-called “debt-equity bias reduction allowance (DEBRA)” that should incentivise companies to finance themselves with more equity instead of debt.

The increasing cost of accessing finance might also reduce the appetite of companies to finance new investments. However, Bruckbauer argued that the financing costs were less relevant for investment decisions than the general economic outlook of companies.

And this outlook has worsened in the past months. For example, Eurostat’s business confidence indicator decreased substantially in the first half of this year, while the economic uncertainty indicator increased over the same period.

“The pain is here and it has not much to do with financing costs but with rising prices and uncertainty,” Bruckbauer told EURACTIV, adding that he expected lower investment growth or stagnating investments due to the uncertainty in the market.

What about “green investments”?

Stagnating investments are bad news for the development of the economy in general, but they could also hurt the green transition. In 2020, for example, the EU Commission estimated that the green transition would require €260 billion in additional investments every year to reach its 2030 climate targets.

Since EU governments are reluctant to mobilise much public money for this, a lot of the financing will have to come through private finance.

However, Bruckbauer said that the nature of the current crisis made green investments more attractive than before. With rising energy prices, both the provision of green energy as well as saving energy is becoming much more profitable, making investments in these sectors more attractive. According to UniCredit Austria’s chief economist, this advantage should outweigh the burden of increased financing costs.

*first published in: www.euractiv.com