What were you doing in 2006? You certainly weren’t fiddling on your iPhone (released June 2007) or listening to Amy Winehouse’s ‘Back to Black’ (released Jan 2008) or watching Lewis Hamilton win his first F1 Championship for that matter (November 2008). Indeed, 2006 seems like a lifetime ago. Greece was just a holiday destination, the Fed was a Swiss tennis player’s nickname and most would have thought quantitative easing was a massage technique.
Why is this important? Well, 2006 was the last time any major central bank increased interest rates (aside from the ECB’s disastrous experiment and quick retreat in 2011).
Since then the world’s financial and monetary policy terms have changed irrevocably, best characterised by an unusual era of rock bottom interest rates. However, come December 16th we are likely to get the first sign that the world may be returning to some semblance of normality with a rise in US interest rates. If and when Janet Yellen and the assembled policymakers of the Federal Reserve’s Open Markets Committee pull the lever to begin a normalisation of monetary policy we can say that normality may be starting to return – even if the Bank of England may not necessarily follow suit.
Normality is a relative state however, and for UK businesses, particularly new smaller businesses that have only ever known the current status of ultra-low interest rates, it is likely that the starting gun of higher rates in the US will begin a period of increased risk due to currency volatility – something I believe the UK’s internationally minded small businesses are ill-prepared for.
Whilst the Fed’s policy makers may pat themselves on the back once they announce the rate rise - as it will be testament to successfully navigating the US economy back to health - outside of Washington the rate rise is not at all welcome.
This is because the divergence of monetary policy and the rise of interest rates is set to boost volatility within currencies, which will make hedging away currency risk, a crucial part of any business’s international dealings, much more expensive and difficult to manage. UK businesses importing and exporting in to emerging markets are likely to be particularly open to currency swings and must prepare and manage their currency strategy accordingly in order to protect margins and profitability.
Whilst the many small and medium-sized businesses that have sprung up since the Global Financial Crisis have played a valuable role in boosting GDP, failure to prepare for the impending currency volatility may seriously blunt their effectiveness.
Worryingly, our research has shown that 70% of British small businesses believe they could be better prepared to deal with exchange rate volatility, with 46% saying having a currency strategy was only of the same priority in 2016 as staff entertainment. Much more needs to be done to educate small businesses about currency risks, otherwise the Fed’s rate rise may cause a wave of negative margin-hitting consequences.
In reality, it is manufacturing businesses that are the most likely to be impacted. Their risk lies in additional volatility clipping already depressed margins caused by commodity price movements. On the flip side, service sector exporters, particularly business to business service providers should avoid the greatest risks, though they too face risk with regards to volatility. Businesses with an exposure to the dollar or dollar-pegged currencies may find that they are the hardest hit if they don’t manage their currency risk, owing to the likely movement against sterling.
So what can businesses do to better manage the risk to their business posed by foreign currency? In my view, for any business, the golden rules when it comes to managing currency risk and implementing a currency strategy are threefold. Initially I think it best to sort out the pricing of contracts that you wish to hedge and then set a budget by looking ahead at the known costs and ensure that these costs 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; are you a risk averse company that is simply looking to protect a budget rate or maybe happy to take on risk in order to outperform current market levels?
Finally, businesses must take into account how the hedge will affect the business cash flow. Different foreign exchange trades carry different levels of risk and you need to be clear on what implications rate moves will have. Also consider whether you are paying a deposit or provided a credit line; hedging is flexible, so a strategy can easily be designed to suit your business’s cash flow requirements.
Moreover, it is not just the likely US rate rise causing currency volatility. Options market volatility is already heightened courtesy of fears over Chinese growth, the fight against ISIS and the UK’s referendum on EU membership among other issues. These events may well cause even greater havoc on sterling and other major currencies in 2016, which again small UK businesses need to prepare for.
The business pages will no doubt cover the aftermath of the interest rate rise in terms of bond yields, equity markets and growth prospects but looking closer to home, unless UK businesses of all sizes are better prepared, then they may be the ones feeling the greatest effects.
Jeremy Cook is chief economist at World First.