„Is it worth postponing planned purchases? How should we adjust sales plans: sell at higher prices because of a shortage of certain raw materials on the market, or sell lower because exchange rate fluctuations have made it possible to buy some raw materials cheaper than usual?
These are the concerns we heard from our customers in the first two weeks of the war. Those who have no direct trade links with Russia or Belarus were also asked these questions. This confusion was also influenced by fluctuations in the currency market,“ says Virginijus Kaušas, head of ArcaPay in Lithuania, a company providing currency conversion and international payment services to businesses.
Currency market fluctuated
„Poland is one of Lithuania’s most important foreign trade partners. Last year, Lithuania’s foreign trade with Poland exceeded EUR 7.27 billion, so the zloty’s exchange rate against the euro is important for Lithuanian businesses that trade abroad. This year, the Polish zloty has also provided a surprise,“ says the financial expert.
On the eve of the war, the zloty was 4.54 zlotys to the euro. After the outbreak of the war, it fell by more than 9% to 4.96 zloty per euro on 8 March. Today it is already 4.63 zloty, only 2% higher than on 23 February, so the trend is still negative against the euro. „Typically, when a foreign currency depreciates, international transactions in that currency become more attractive for businesses, which means that it is possible to buy goods or services from that country at a better price than before,“ explains Mr Kauš.
During the same period, the US dollar reversed against the euro. As a result, on 8 March, the US Dollar was 4% more expensive than on the eve of the war. This means that on 8 March, Lithuanian businesses abroad were paying more for goods in US dollars than on the eve of the war. According to Mr Kaušas, they are still paying more today because of the exchange rate, although the difference is not as significant.
„Today, the currency market, which experienced the turbulence of the war, is slowly getting back on track. However, businesses should not be happy about this – It has to be admitted that the war and the plans of the central banks will not allow Lithuanian businesses to sleep well in the near future,“ says the expert.
Not only the war but also the plans of the central banks will keep businesses awake for years to come
After the 2008 crisis, central banks have been doing their utmost to stimulate the economy by cutting interbank lending rates. No central bank in the G7 has set an interest rate above 2.5% for more than ten years. Most have been close to 0% or even negative. According to Virginijus Kaušas, this has helped the economy catch up. Therefore, in 2018, there was already talk of reducing this economic stimulus, but then Covid-19 intervened. Fears that economic growth would stall again gripped the markets, and stimulus packages were put in place worldwide. This stabilised the situation.
„Today, the global economy is strong, and interest rates are very low. But unfortunately, inflation continues to rise. This has been especially true in Lithuania since last October when the spike in inflation was mainly caused by supply chains that failed to keep up with the recovery in demand, the increased cost of energy and other raw materials, and the rising prices of goods and services. The only way for central banks to contain this inflation is to raise interbank lending rates,“ explains the expert.
This train is already in motion, he says. In recent months, there have already been announcements by the European Central Bank, the Polish Central Bank, the Bank of England, and other central banks of plans to raise interest rates. Some have already done so.
Rising interest rate differentials: what does this mean for dollar transactions?
„The European Central Bank has so far been the slowest to react to market dynamics. So far, it has only hinted that it will start raising interest rates at the end of the year. Meanwhile, the US central bank has already raised it and said it would raise it six more times this year.
It is clear that, in this situation, the interest rate differential between the euro and the dollar will widen. This is particularly important because Lithuanian businesses are nowadays making most of their international foreign currency transactions in dollars,“ he says.
The map of Lithuania’s foreign trade indicates that almost half of all transactions do not involve some form of currency conversion. According to Statistics Lithuania, Lithuania’s main foreign trade partners in 2021 were Russia, Germany, Poland, Latvia, the Netherlands, Sweden, Estonia, and others.
Historical data shows that Lithuanian businesses transacting in USD when the USD price is rising should consider currency risk management measures.
Smaller businesses find it difficult to manage the risks of exchange rate fluctuations
According to the head of ArcaPay, there are three ways to manage exchange rate risk.
„The first is to try to transfer the risk to the other party – i.e. the supplier or the customer. In this case, we require the goods to be purchased or sold in the currency we are comfortable with, i.e. euros.
„The second way is to look for ways to balance income and expenditure in the same foreign currency. However, it is not so simple in the short term and can only be effectively applied in the case of large corporations.
„A third way is to use derivatives – i.e. forwards or options. Options are a rather complex instrument, acting as an insurance policy, and therefore have a high cost. Meanwhile, forwards, which allow a company to fix the exchange rate at which it will pay its suppliers in the future or sell goods, are perhaps the simplest option.
„And fourthly, of course, it is possible to simply assume the currency risk, in other words, to do nothing. Especially if international trade is a small part of the company’s business,“ he says.
Banks won’t throw a lifeline to the small businesses
„There is a caveat about forwards – banks, which are the main financial partners of most businesses, are not interested in smaller players in the market, whose foreign currency operations amount to only tens or hundreds of thousands of euros per year.
Therefore, small businesses will not be able to obtain a forward transaction service from a bank in an expeditious manner and will certainly not be offered by a bank to proactively use such instruments to manage their business risks. The bank does not have the tools to do so. It is not flexible enough, and, ultimately, its business strategy is geared towards other priorities.
The paradox is that it is usually the smaller banks that are more sensitive to such exchange rate fluctuations, and for them, such a service is certainly relevant. To make it clearer what kind of financial risks we are talking about, we can model a typical situation of a medium-sized business operating in an international market,“ says Mr Kaušas.
In the case of a forward transaction, the fixed exchange rate for the conversion is determined by the euro interest rate, the dollar interest rate, and the current exchange rate between the euro and the US dollar. Usually, the longest period for which it can be fixed is a year.
„So if a company planned to buy commodities or equipment in the coming year, for example, for EUR 500,000 in US dollars, we would see that if the exchange rate was locked in, the whole amount would end up being converted at a more favourable rate, with a total difference of over EUR 7,000 compared to the spot market. This is quite a significant difference, especially if the company operates in a lower margin market,“ he models the situation.
Only 2.5% of foreign trade transactions last year took place at pre-fixed exchange rates
Paradoxically, according to the Bank of Lithuania’s data today, only a small part of foreign trade transactions – 2.5% – were forward-fixed last year (USD 0.9 billion, EUR 0.68 billion, and 0.25 billion in other currencies). Nevertheless, Lithuania’s total foreign trade volume in 2021 will exceed EUR 70 billion (EUR 34.75 billion in exports and EUR 37.75 billion in imports). „Why is this the case? Mostly due to a lack of basic knowledge on how to manage such risks,“ explains the financial expert.
„Knowing the volume of international transactions you are planning and your tolerance for financial risk, anyone monitoring the currency market can assess whether a threshold has been reached at which it would be appropriate to look for solutions to manage currency market risks. Ideally, however, such decisions on managing these risks should not be taken here and now, when a favourable situation in the currency market is observed, but at the Board level, several years in advance.
The question here should not be primarily how and how much we want to save or gain from exchange rate fluctuations, but whether we want to eliminate these risks altogether. Forward contracts are therefore seen as a guarantee of stability. It is a clear knowledge of the circumstances in which a particular company will be transacting with its business partners in foreign countries in the coming months or years. And stability is probably what we look for most in business risk management when there are so many dynamics in the financial markets and geopolitical shocks,“ says Mr Kaušas.