Understanding the Impact of Interest Rates on SMEs

Various factors contribute to the success or challenges faced by businesses in the dynamic landscape of South African SMEs. One crucial element that significantly influences business operations is the interest rate. In this blog, we’ll explore the concept of interest rates and discuss their impact on businesses.

The Current Economic Climate

In the latest 2024 National Budget Speech, South Africa’s weak economic performance is set to lead to a sharp deterioration in tax revenue collection for 2023/24. With this in mind, the government has proposed certain tax measures to alleviate immediate fiscal pressure and support debt stabilization. Finance Minister Enoch Godongwana reported that tax revenue for 2023/24 is projected at R1.73 trillion, which is R56.1 billion lower than estimated in the 2023 Budget. The shortfall is largely due to a decline in corporate profits and revenue from mining taxes. Over the medium term, revenue projections are R45.6 billion higher than the 2023 Medium Term Budget Policy Statement (MTBPS) estimates, which include increased personal income tax and additional revenue proposals.

Consumer Price Inflation (CPI) has also ticked up at the start of 2024, though softening food prices provide some relief for cash-strapped consumers. The categories with the largest annual price increases included restaurants and hotels at 8.0%, food and non-alcoholic beverages at 7.2%, and health at 6.5%. At the time of publishing this article, South Africa’s repo rate was 8.25%, and the interest rate was 11.75%.

Understanding the Interest Rate

Let’s begin with some definitions and how they all work together.

The Repo Rate: The repo rate, or repurchase rate, is the rate at which a country’s central bank lends money to commercial banks. In South Africa, this rate is set by the South African Reserve Bank (SARB). When traditional banks need funds, they can borrow from the central bank, and the repo rate is the interest charged on these loans.

The Interest Rate: The interest rate is the cost of borrowing money or the return on investment for lending money. It represents the percentage of the loan amount that a borrower pays the lender as compensation for using the funds. Typically expressed as an annual percentage, it applies to various financial products, including loans, credit cards, and savings accounts. The central bank uses the interest rate to manage inflation; when inflation is high or rising, the central bank may increase the interest rate to reduce borrowing and spending.

Inflation: Inflation refers to the sustained increase in the general price level of goods and services in a country over a period. This means that, on average, prices are rising, and the purchasing power of money is decreasing. Inflation is usually measured as an annual percentage rate, reflecting the percentage change in prices compared to the previous year. Various factors can cause inflation, including increased production costs, a decline in the value of the Rand, unexpected disruptions in supply, political instability, or changes in consumer demand.

How These Rates Work Together: Understanding how interest, repo, and inflation rates work together is crucial for determining loan rates. Traditional banks play a key role in lending, and when determining interest rates on loans, they consider the repo rate as a benchmark. The repo rate set by SARB serves as a signal for the overall cost of borrowing in the economy.

SARB regularly reviews and adjusts the repo rate to manage the country's monetary policy and economic conditions, based on factors like inflation, economic growth, employment rates, and currency stability.

When the repo rate changes, it affects the cost at which traditional banks can borrow money from the South African Reserve Bank. If the repo rate increases, it becomes more expensive for banks to borrow funds. Conversely, if the repo rate decreases, banks can access funds at a lower cost.

Banks consider their borrowing costs, including the repo rate, as well as operational expenses and credit risk, to determine the interest rates they offer consumers. When the repo rate increases, banks raise their interest rates on loans to offset higher borrowing costs. Conversely, if the repo rate decreases, banks may lower their lending rates, making borrowing more affordable.

Other factors, such as market conditions, borrower creditworthiness, and competition among lenders, also influence loan rates. Still, the repo rate serves as an important reference point in this process.

The Impact of Interest Rates on SMEs

Consumer Spending: Following the latest budget speech, various industries expect above-inflation increases, such as the alcohol industry, which anticipates increases between 6.7% and 7.2%. For example, a can of beer may increase by 14 cents, while a bottle of wine will cost an extra 28 cents. National Treasury also proposed increasing tobacco excise duties by 4.7% for cigarettes and cigarette tobacco, and by 8.2% for pipe tobacco and cigars. This translates to a R9.51 increase for cigars and 97 cents for a pack of cigarettes.

As interest rates rise, borrowing becomes costlier, leading to reduced consumer spending overall. Businesses then experience a decline in sales as customers cut back on discretionary purchases. This shows how interest rates directly impact consumer behavior and purchasing power. When interest rates are low, borrowing becomes more affordable, stimulating consumer spending, which benefits SMEs through increased demand and higher sales volumes.

Cost of Borrowing: Some businesses rely on credit to finance inventory, equipment purchases, and expansion plans. Changes in interest rates influence the cost of borrowing capital from banks or other financial institutions. Low interest rates allow businesses to obtain loans at favorable terms, reducing overall financing costs. Conversely, higher interest rates increase borrowing costs, potentially squeezing profit margins and limiting expansion opportunities.

Often, SMEs turn to alternative funding providers like Merchant Capital, which offer a fixed cost of funding instead of fluctuating interest rates based on economic factors.

Debt Servicing: SMEs with existing debt obligations are directly affected by interest rate fluctuations. When rates rise, the cost of servicing existing loans increases, putting a strain on cash flow and potentially affecting their ability to meet other financial obligations, such as payroll and supplier payments. In extreme cases, high interest rates may lead to defaults and insolvency for highly leveraged businesses.

Investment and Expansion: The interest rate environment influences investment decisions for SMEs. Low interest rates encourage businesses to invest in new stores, renovate existing premises, or upgrade technology and equipment. Lower borrowing costs make expansion plans financially viable. Conversely, high interest rates often deter businesses from pursuing growth initiatives, as the cost of capital becomes prohibitive. Business owners may delay or scale back expansion plans, impacting job creation and overall economic growth.

Exchange Rates and Imports: A higher interest rate compared to other economies may attract foreign investors seeking better returns. This influx of foreign capital can strengthen the local currency, making imports relatively cheaper for SMEs. Conversely, lower interest rates compared to other countries may lead to capital outflows, weakening the currency and making imports more expensive. SMEs relying on imported goods may face higher costs and need to adjust pricing strategies to maintain competitiveness.

The Bottom Line

The impact of the current interest rate on businesses highlights the importance of adaptability and strategic planning. By staying informed, monitoring market trends, and implementing proactive measures, SMEs can navigate the ever-changing interest rate landscape and position themselves to survive and ultimately thrive.

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