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Keep the Caution Flag Up

05/10/2009


Farming is not a race to the finish line. Similar to a car race, a yellow flag is signaling some potential danger ahead. In the past few months, there has been quite a bit of discussion about the potential rise in interest rates. As of now, that’s all it’s been – a discussion - as interest rates continue to hover at historical lows. It is important to keep in mind that familiar warning signs indicate that this could change. I recently attended a conference in the United States where five economists presented their thoughts on the economy, both in the U.S. and globally. Admittedly, the discussion was focused around the U.S., but our economies are related closely enough that it warrants our attention.

There is a saying that states you could line up all the economists in the world and they still would not reach a conclusion. However, during this conference, they all agreed on one thing – interest rates will rise significantly. They did not agree on the time line as to when this will happen (ranging in their predictions from 18 months to 3 years), nor did they agree on the severity or the duration. The range for the rate peak varied from 9 – 11%. One of the economists quoted Alan Greenspan as predicting 12 – 15% interest rates within 3 – 5 years, not predicting how long they would remain at those levels but predicting that they will be high enough to correct imbalances in the economy.

Warning Signs
Unfortunately, it is not possible to predict the future with certainty. All we know is the history of events and outcomes of similar circumstances. In the past, periods of recession have been followed by inflationary periods. When Governments are spending money to break the recession (as currently is the case), historically there has been a significant increase in interest rates. The degree of inflation is variable, dependant upon the severity of the recession and the amount of Government intervention required to stimulate the economy. Government is limited in what it can do to manage the inflationary pressures. One tactic is to use interest rates to manage the demand for capital that correlates to periods of inflation.

One economist talked about different types of inflation:

  • demand pull (where interest rates increase due to consumer spending)
  • cost push (where interest rates increase due to cost increases)

He noted that the last time there was a cost-push inflationary period was in the 1980’s and we know what interest rates did at that time.

Another economist warned that the world may stop buying U.S. treasuries. The U.S. dollar can provide some forewarning as to the likelihood of this occurring. As the rest of the world starts to come out of the recession and investors gain confidence in the recoveries, the world will begin to invest outside the ‘safe haven’ of the U.S. treasuries, if the U.S. cannot report the same performance. This will cause the U.S. dollar to decrease in value and the U.S. would be forced to increase interest rates to prop up the dollar and to attract investment.

Conclusions and forecasts of the economy from the presentations include:

a) Higher cost structures and greater variability
b) Higher inflation
c) Higher interest rates
d) Changes within the business environment, including an increase in operating  risk of business for farmers

What a Farmer Can Do
Working from the premise that you control what you can control, managing costs should be a priority, including interest expense. For a long time, farmers have not had to focus a lot of management attention on interest costs, but higher operating risk necessitates lower financial risk (reduced leverage, interest expense). It is easier to leverage up than it is to de-leverage. In a scenario where interest rates increase to 12% and farmers find themselves unable to sustain positive cashflow, will they be able to re-structure their debt?

Farmers will be well-advised to pick a worst-case interest rate scenario and:

  • Calculate the impact of the higher rates on cash flow
  • Calculate debt servicing ability with the higher rates
  • Determine the likelihood of being able to re-structure (term out) current debt
    • Give consideration to equity being available for security and historic earnings to support higher term debt repayment requirements with the re-structuring


Terry Betker is a partner with Meyers Norris Penny LLP, working out of the Winnipeg, Manitoba office. He is director of practice development in Agriculture – Government & Industry. He can be reached at 204.782.8200.