2016 has not been a calm year so far. Financial markets have fallen, and then bounced back on issues as disparate as the Chinese economy, Italian banks and Brazilian corruption charges, while political spectres like the forthcoming UK referendum on European Union (EU) membership, the migrant crisis and US presidential primaries are also looming large.
Small and medium-sized businesses looking to expand their operations this year will naturally turn to the prospect of dipping their toes in a new international market. However, there is no reward without risk, and the decision to operate internationally brings responsibilities that businesses may not have dealt with in the past.
UK small- to medium enterprises (SMEs) are regularly characterised – and rightly so – as the lifeblood of the British economy, with many springing up since the 2008-09 global financial crisis to play a valuable role in helping to boost gross domestic product (GDP). However, failure to prepare for impending currency volatility may seriously blunt their effectiveness.
Indeed, a survey issued by World First in January of over 1,000 senior decision makers at UK-based SMEs making cross-border payments found that although 75% feared that currency volatility from the upcoming EU referendum would impact their business, almost half (47%) are failing to take any notice of foreign exchange markets and over a third (35%) believe that having a currency strategy is not important.
Furthermore, 45% agreed they have been caught out by sudden movements in exchange rates in the last 12 months, with one in four (26%) saying they had been ‘severely impacted by market volatility’.
A cocktail of risk
So where is this volatility likely to come from? You can literally take your pick.
The UK referendum has to be the greatest pressure on the pound at the moment. Political risk is toxic for a currency and the referendum on the UK’s continued membership of the EU represents the latest risk for sterling.
Having said this, the referendum is not the only negative impulse on the pound at the moment. Since the summer of 2015 we have seen economic data produced by the UK start to weaken. Inflation has remained at or near zero, wages are stagnant and growth has been unable to reach what economists have come to term ‘escape velocity’. As such, expectations around an imminent Bank of England (BoE) interest rate rise have withered and died. In fact, some markets are now going so far as to predict a cut this year.
Elsewhere, there is a lot of shrugging going on in currency markets at the moment. Recent moves by the European Central Bank (ECB) and the central banks of China, Japan and the US – be it new stimulus plans, making interest rates negative or increasing them for the first time in six years – have all generated huge amounts of volatility and this is not set to stop anytime soon.
So what can businesses of all sizes do to better manage the risk to their business posed by foreign currency?
At the very minimum, their treasury departments need to sort out the pricing of contracts that they wish to hedge. They can then set a budget by looking ahead at known costs and ensuring that these are covered. Budget levels can be protected via forward contracts or currency options at the time of setting the budget.
Secondly, businesses need to consider their objectives when hedging. Is the company a risk averse one that is simply looking to protect a budget rate, or maybe it is happy to take on risk in order to outperform current market levels?
Finally, companies must take into account how hedging will affect their cash flow. Different foreign exchange trades carry different levels of risk so they need to be clear what implications rate moves will have. Also to be taken into consideration is whether the company is paying a deposit or has been provided with a credit line; hedging is flexible, so a strategy can easily be designed to suit its cash flow requirements.
Trading internationally can make businesses world-beaters almost overnight. Mini-multinationals that don’t have the balance sheet strength to absorb major exchange rate shocks need to look at ways of protecting themselves from today’s turbulent markets. The survey has shown that there is a widespread lack of appreciation on how such rate movements can impact a company’s bottom line – hedging its currency exposure can prevent a business from becoming a statistic.
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