January Key Indicator – exchange rates and their impact on SMEs

The exchange rate is the value of a country’s currency against those of others and the factors affecting this are many, especially in a volatile political climate, both globally and locally.

Among the influences are the interest rates set by central banks, inflation, a nation’s gross domestic product and trade balance, its debt and to a significant extent, the behaviour of politicians and governments towards both their own and competing economies.

Significant fluctuations in exchange rates, as has been seen over the last couple of years, then start to affect the confidence of investors, currency traders and businesses, increasing the volatility of currency values and stock exchanges.

Two obvious examples have been the plummeting value of ￡Sterling since June 2016, when the UK voted to leave the EU, despite occasional upticks as the negotiations over the withdrawal agreement dragged on.

Similarly, the engagement of the US President, Donald Trump, in imposing tariffs and instigating trade wars with other competing economies, particularly China, has arguably had a negative impact on both the value of the US Dollar and the performance of its own stock market.

Economic recovery, particularly in the UK and USA, has, in any case been sluggish in the decade since the 2008 global economic meltdown, which prompted central banks to set interest at very low rates in an attempt to protect their countries’ economies by stimulating investment and business activity.

A little history on exchange rates and currency values

Until the early 1930s, countries’ currencies were valued against the value of gold – the gold standard.

The quantity of gold held by a country determined the value of its currency and under the gold standard trade between countries was settled using physical gold. So, nations with trade surpluses accumulated gold as payment for their exports. Conversely, nations with trade deficits saw their gold reserves decline, as gold flowed out of those nations as payment for their imports.

The UK abandoned the gold standard in 1931 and the US in 1933, moving instead to the current fiat system, where currency values fluctuate dynamically against other currencies on the foreign-exchange markets. Fiat money is the currency that a government has declared to be legal tender, setting it as the standard for debt repayment. Essentially its value is based on market perception.

It has been argued that moving off an actual physical commodity like gold has made currency values and therefore exchange rates more vulnerable to manipulation by politicians and central banks, and therefore created a more volatile and vulnerable economic climate. This is where the market's interpretation of politicians and central bankers is fundamental to currency values.

The effect of exchange rates on business

It is not only exporting businesses that are affected by exchange rates and currency values.

A good recent example has been the benefits to some UK SMEs, particularly in the service and hospitality industries, which during the summer of 2018 experienced something of a boom in tourism from a combination of a long season of good weather and the decline in the value of ￡Sterling making it cheaper for foreign tourists to visit the UK.

On the other hand, even small local SMEs whose businesses depend on selling goods and services where parts, components, food ingredients or raw materials come from overseas saw their costs rising because ￡Sterling’s buying power had been reduced in comparison with currencies in other countries.

Can SMEs protect their businesses from exchange rate fluctuations?

It can be harder for SMEs to protect themselves than it is for larger businesses, but the essentials for any business survival and growth are based on managing their costs and expenditure with strict and careful attention to cash flow which is best achieved by close scrutiny of monthly, or more frequent, management accounts.

If it is at all possible to manage cash flow in a way that a business can create a contingency reserve this will provide some measure of protection to a downturn in the exchange rate.

For those that have to source supplies from overseas, hedging against cost increases due to exchange rates can be done by negotiating a forward contract in your own currency based on a set price with the supplier or at least fixing the price with purchase of a forward exchange rate. This may mean missing out on future changes in the exchange rate that might benefit the SME buyer, but will provide some degree of certainty when planning ahead.

Another option may be to include clauses in your contracts which allow you to renegotiate prices should the exchange rate change significantly within an agreed period of time.

Wherever possible try to avoid the transaction fees charged by banks for making international payments. Some money transfer specialists offer an alternative, FCA regulated, service in a free multi-currency account that lets businesses hold over 40 currencies, and switch between them using the mid-market exchange rates to make payments.

While the risks of fluctuating exchange rates can be greater for SMEs with fewer reserves to fall back on planning and good communication can help to mitigate at least some of the risks.