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Monetary policies of central banks as a key factor affecting business financing

High inflation rates are currently hampering economies overall throughout the world. In Germany, the inflation rate in November 2022 was 8.8%, which constituted a new historic peak level since the introduction of the Euro. The aim of more restrictive monetary policies of central banks is to curb inflation and restore long-term economic stability. By raising key interest rates and withdrawing liquidity it is hoped that the inflation rate trend can be broken and it is accepted that there will be higher financing costs. Nevertheless, the risk of a more protracted recession is currently assessed as being high.

The significance of monetary policy 

The aim of monetary policy is to keep the prices of goods and services stable over a longer time period. Stable money promotes economic growth and allows savers to securely build wealth. A considerable loss of purchasing power erodes the trust of the general public in the currency. 

Favourable financing options are essential for most businesses in order to increase growth and profits in the long term. During periods when the interest rates on capital markets are low, a high debt ratio is generally not an obstacle to generating a hefty return on equity; however, during periods when the interest rates on capital markets are high, it is important to have good balance sheet quality with sufficient equity. 

In terms of industries, there are marked differences here; sectors where the debt ratio has historically been higher are more sensitive to changes in monetary policy – current examples are the real estate sector, the technology sector and young start-up companies. 

Example: Vonovia, Germany’s largest real estate company, is a good example in this respect. In 2022, the Vonovia SE share price suffered considerable stock market losses on the back of sharply rising market rates. Even though Vonovia has a balanced financing structure for the long term, against the background of a changing interest rate environment and with a view to profitability and the debt ratio, Vonovia’s business model was however re-evaluated by investors. Record rental income and a portfolio – consisting of approx. 650,000 residential units – that is effectively fully let were apparently of secondary importance here because the share shed approx. 53% of its value in the 2022 financial year. 

Measures taken by central banks

A central bank has various monetary policy tools at its disposal that can be adjusted at short notice if required. 

Open market operations

Central banks employ so-called open market operations to manage the liquidity available in the market. The amount of money available is artificially influenced through the purchase and sale of securities. If a central bank buys a security (e.g. a government bond) this results in an increase in the money supply of the national economy. Conversely, the sale of a security will lead to a contraction of the money supply. Market rates will likewise be affected by the impact of open market operations because changes in the money supply will have an indirect effect on borrowing costs.

Standing facilities

In the case of standing facilities, the initiative comes from the commercial banks. The facilities are supposed to provide or absorb so-called overnight liquidity. As a consequence, the partner banks are able to bridge any short-term liquidity overlaps. The deposits and financing interest rates of the standing facilities are especially relevant for short-term interest rates (e.g. overnight money). Long-term market rates are however based on the expected development of the individual future monetary policy decisions concerning the standing facilities. 

Please note: This is the most effective means that a central bank has to manage monetary policy because a central bank itself is able to adjust interest rates. 

Monetary policy of central banks and forecasts of future developments

It is not possible to reliably forecast the future development of the monetary policy decisions of a central bank since this depends on a wide variety of influencing factors. Economic indicators such as inflation, economic growth, the unemployment rate and the stability of financial markets are constantly changing and can swiftly alter – this then affects the daily updated monetary policy of the central banks. Central banks have to be flexible so that they are able to react to unforeseen events. 

Please note: The introduction of central bank digital currencies (CBDCs) is likely to radically change the way that central banks operate monetary policy in the future. These new instruments could make it possible for the central banks to pay out money directly to citizens and exert more control over the money supply.

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