Weathering the Storm of Rising Interest Rates: Navigating the Financial Landscape

Interest rates are like the weather. We can prepare for typical fluctuations, but sudden changes can still catch us by surprise. After the global financial crisis (GFC), for example, we enjoyed a decade of clear skies and low rates. Even as the winds rose in 2019 and the economy struggled with a higher federal funds rate, the gusts soon dissipated and zero interest rates returned.

But in the last two years, the interest rate equivalent of a violent storm has descended. Desperate to battle inflation, the US Federal Reserve has hiked at an unprecedented pace as the federal funds rate hit its highest point in more than 22 years, with a target range of 5.25% to 5.50%. The Fed’s moves have caught many unprepared.

Consider Saudi Arabia. Its private sector has experienced remarkable credit expansion in the last few years. The July 2023 Monthly Statistical Bulletin from the Saudi Central Bank (SAMA) indicates that banks’ credit exposure to the private sector grew at a compounded annual rate of 10% from 2018 to 2022. This growth culminated in a record outstanding credit of SAR 2.4 trillion, or the equivalent to US$0.64 trillion. Notably, almost half of this exposure has a maturity period exceeding three years.

Meanwhile, since the launch of the 2030 Vision, Saudi Arabia has announced around US$1 trillion in real estate and infrastructure projects. Last June, the National Privatization Center & PPP (NPC) declared a pipeline of 200 projects across 17 sectors, reinforcing the commitment to public-private partnership initiatives.

These initiatives, combined with the massive credit expansion in the private sector, mean that many projects have long-dated floating borrowing exposure. And interest rate volatility has put them under more pressure than ever before. The risk? Failing to accurately plan for rate changes. The consequences? Spiraling costs, blown budgets, and an uncertain future.

The question is, How do we navigate this storm?

The Financial Model and Interest Rate Assumptions

Interest rate assumptions are central to leveraged transactions with extended exposure. For long-term projects under SAR borrowing, liquidity typically permits hedging for five to seven years. Consequently, lender covenants require many projects to hedge a substantial portion of this borrowing.

But how do we address the exposure’s remaining lifespan? Many projects apply static, unsubstantiated interest rate assumptions, particularly for periods beyond 7 to 10 years. These are clearly unsuitable for today’s climate of evolving rates. Therefore, the models have to be recalibrated to reflect elevated rates and a reasonable interest rate curve extrapolated.

Addressing the Present Dilemma

Adjusting models to the current interest rate environment after the fact will undoubtedly affect core profitability metrics and may even compromise a project’s financial viability. The ramifications grow more severe with increased leverage. Yet failing to address the problem will only compound the negative consequences.

Projects facing higher interest rates need to update the models to assume a painful current environment if the floating debt portion is material. This challenge remains even when the debt is partially hedged. Therefore, the project company has to examine long-term borrowing implications as well as the immediate exposures. So, how should companies navigate this environment? And is derivative hedging the only answer?