Do higher interest rates lead to lower investment?
According to theory, an increase in interest rates would lead to a decline in investment because higher interest rates drive up firms' funding costs, which makes investment plans less attractive. Evidence from empirical literature is nevertheless mixed, with many studies demonstrating no such relationship. However, many empirical studies employ aggregate data, and it is likely that the resulting findings conceal significant heterogeneity between firms, that could be revealed if micro data were used. As monetary policy transmission affects firms on an individual level, understanding this heterogeneity is important.
In order to allow for heterogeneity between individual firms, we have analysed the link between investment and the interest rate at the firm level, with data on the euro area firms from the Survey on Access to Finance of Enterprises (SAFE). Firms are asked whether their investment has increased, remained unchanged or decreased over the past six months. At the same time, they are asked to report whether the interest rate charged by the bank increased, remained unchanged or decreased in the same period. Only those firms that indicated they applied for a bank loan in the past six months were asked to report the change in the interest rate charged. The analysis also takes into consideration other factors which can influence firms’ investment decisions, such as future growth expectations, changes in profitability, indebtedness and credit demand, and specific characteristics such as firm size, age and sector.
Firms’ growth prospects affect the interest sensitivity of investment
Our results support the prevailing theory. (link naar achterliggend document) Euro area firms that face an increase in interest rates are more likely to decrease investment compared to firms subject to unchanged interest rates. Similarly, firms exposed to falling interest rates are more likely to increase investment. The results of the study reveal that the extent to which firms reduce investment in response to rising interest rates depends on their growth prospects in the medium term. In particular, firms expecting favourable revenue growth over the next two to three year are less likely to cut investment in the face of rising interest rates. These firms presumably have greater investment opportunities, and are therefore unlikely to be discouraged by a higher interest rate environment. Conversely, the effect of lower interest rates on investment does not differ in accordance with firms’ growth prospects.
Another factor affecting the interest rate sensitivity of investment is whether a firm experiences financial constraints, i.e. difficulty obtaining access to finance. The findings suggest that firms facing financial constraints are generally more likely to reduce investment in response to rising interest rates than firms without financial constraints. On the other hand, firms with financial constraints are not more likely to increase investment in response to reduced interest rates compared to firms without financial constraints.
We generally find a statistically significant and negative relationship in the euro area between interest rates and investment at an individual firm level, in line with conventional economic theory. As firms with favourable growth prospects are less likely to decrease investment in response to an interest rate increase, the current favourable euro area economic outlook would imply a moderate decline in investment on the back of higher interest rates.