With Interest Rates on the Rise, What Is the Impact on Currencies, Taxes and Foreign Investment?

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With renewed talk on continued U.S. interest rate hikes, corporate financial offers need to get a grip on the ensuing impact of higher rates on the economy, currencies, and business investment.

One thing is for sure—the Federal Reserve is pointing directly to higher rates. This from the minutes of the Sept. 25-26 Federal Open Market Committee, released on October 17:

Gradual increases in U.S. rates are tightening financial conditions globally

"Participants generally anticipated that further gradual increases in the target range for the federal funds rate would most likely be consistent with a sustained economic expansion, strong labor market conditions, and inflation near two percent over the medium term," the Federal Reserve minutes stated.

Recent U.S. rate hikes are already having an impact on global markets, especially in one key area: “Gradual increases in U.S. rates are tightening financial conditions globally, and have contributed to bouts of volatility and sharply depreciating emerging market (EM) currencies," states BlackRock Investment Institute, in a recent research note.

Direct Business Impact of Higher Business Rates

With rising government deficits and inflation inching up in major global bourses, the question for corporate financial decision makers is this: how will rising interest rates impact my company's ability to do business at home and overseas?

By and large, more robust interest rates act as a moderating influence on economic growth, and not in ways that are usually beneficial to companies. Here's a snapshot of how rising interest rates directly impact businesses and investment:

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"Big picture" impactors: When interest rates inch upward, the impact is gradually felt in these key corporate financial areas:

  • Higher interest rates boost the cost of borrowing capital.

  • Rising interest rates also curb disposable income among consumers.

  • Higher interest rates also slow economic growth and take some of the edge off of rising inflation.

Higher interest rates attract more foreign investment: Hot money flows, i.e., the flow of investment from one country to another country to capitalize on interest rate fluctuations and on anticipated exchange rate fluctuations, are impacted by higher rates. For example, companies and investors are more likely to park capital in U.S. banks as the Federal Reserve engages in a series of interest rate hikes. That's because rate appreciation translates into higher investment gains with U.S. financial institutions in a rising rate environment.

Currency values rise: By and large, rising interest rates are a solid indicator that a country's economy is on an upward path, and companies are more likely to invest in burgeoning economies. When businesses begin to favor local currencies, the value of that currency rises.

Country export scenarios weakens: In a higher interest rate environment, country exports weaken, while imports tend to become more competitive, as currency values strengthen. For instance, a stronger dollar makes it more likely companies doing business in countries that haven't hiked rates (like China, which has largely maintained its interest rate levels in 2018) will steer more business investment to the U.S. to capitalize on a stronger dollar and a more robust economy.

Rising interest rates lead to higher taxes: In the U.S., the talk from the White House focuses on a continuation of lower tax policies, but that runs against taxation trends in a rising rate environment. Here's why – higher interest rates hike the already high cost of federal government interest payments on borrowed debt, leading to government budgetary pressures. One of the easiest ways out for economic policy makers is to advise the federal government to boost taxes to cover those higher interest payments, thus making it more expensive for companies to conduct business in that country. That's one reason why President Trump has been such a harsh critic of the Federal Reserve's rate hikes – they threaten the viability of more U.S. tax cuts.

With the U.S. leading the way, rising rates are here for a while, and corporate financial decision makers need to act accordingly.

Time to Adjust?

As inflation continues to rise in key global bourses like the U.S., Europe and, Pacific Rim countries like Japan, expect central banks to keep inching rates upward in order to keep inflation in check.

In that scenario, corporate financial officers need to adjust their expectations on issues like direct investment, currency strategies, and on tax payment expectations. With the U.S. leading the way, rising rates are here for a while, and corporate financial decision makers need to act accordingly.