In 2022, we have seen an unprecedentedly fast rise in inflation to levels last seen in the 1970s. The persistently high inflation is a concern for both individuals and businesses because it reduces purchasing power, which can lead to lower profits, increased expenses, and in some cases, severe economic hardship.
Contrary to the initial expectation of central banks, inflation will not go away quickly. So, what does persistently high inflation mean for your international payments and businesses dealing in foreign currency?
We explore the additional risks inflation introduces to foreign currency transfers and holding foreign currency and how your business can best deal with it.
How does inflation affect international payments?
At first glance, inflation should not significantly impact how companies deal with international payments, as these days, payments are increasingly instant, global and available 24/7 – even on weekends.
So high inflation in one country or many countries in tandem should not affect the level of risk of most currency transfers. However, inflation introduces many secondary effects, which increase companies’ overall risk when dealing with foreign exchange and international payments.
Most pronounced, inflation leads to currency debasement over time. It erodes purchasing power, and in case the central bank does not deal with inflation by aggressively raising interest rates to achieve an expectation of positive real rates, the currency will debase over time.
In 2022, this effect was seen most prominently in the debasement of the Japanese Yen vs the US Dollar and other currencies. The Japanese Yen lost more than 25% against the US Dollar in 2022. This was driven by the unwillingness of the Japanese Central Bank to raise interest rates. As a result, although inflation in Japan is much lower than in the United States, the market started to price in fear of inflation in Japan catching up and real interest rates persisting in being negative for a long time to come.
Hence, the Japanese Yen has sold off steadily. As a result, companies exposed to the Japanese Yen, such as exporters into Japan, were at risk in case they did not hedge their JPY exposure.
Elevated FX volatility
While it is possible for a business to hedge against currency debasement in the forward market, elevated FX Volatility can introduce additional risks even to fully-hedged businesses.
In 2022, FX volatility in the British Pound exploded after the announcement of the mini-Budget under Liz Truss and Kwasi Kwarteng. The British Pound lost more than 20% versus the US Dollar within days.
The market was concerned that the stimulant budget would lead to an unmanageable public-spreading deficit and have a further inflationary effect, counteracting the Bank of England’s work to curb inflation by raising interest rates.
Businesses spooked by the sterling’s high volatility faced a tough decision – hedge future exposure in other currencies or wait until the issue abates and the Sterling recovers?
Eventually, a panic reaction due to the steep selloff would have cost businesses a lot of money.
With elevation staying elevated around the globe, we will likely see similar situations in the future when different countries try to balance the needs of protecting the economy, supporting people in hardship, and managing public finances.
More frequent FX interventions
As inflation increases FX volatility, it also increases the probability of FX interventions by Central Banks. Over the last decade, we have seen FX interventions primarily in emerging market countries such as Russia, Kazakhstan and Turkey.
However, high inflation in developed markets makes FX interventions by central banks more likely, especially in the instance of a sudden collapse in the currency.
In 2022, the Bank of Japan intervened in the FX market to halt an accelerated collapse in the Japanese Yen.
FX interventions by central banks can be very costly for international payment transfers because they are suddenly distorting the free market and moving the value of a currency pair by many percentage points within a minute or less.
Hence, anybody dealing in large foreign currency transactions should make sure to plan hedging and exposure well ahead rather than undertaking a transfer just when needed — it might just be the very moment when a central bank decides to intervene and move the market in the opposite direction.
Illiquid FX markets
More political and central bank influence on exchange rates is expected because of high inflation. Many countries would like their population to believe that inflation is under control and a simple way of doing this is by managing or capping the exchange rate of their currency.
Especially in emerging economies, it has been a playbook move against an impending currency crisis to limit transactions in foreign currency to a certain amount or cap.
Turkey has introduced a complex system of artificially controlling its exchange rate to show stability and stimulate the domestic economy, which relies heavily on imports.
For businesses dealing in emerging markets, this means an increased risk of illiquid FX markets, where overnight, they might be unable to hedge their exposure or have to deal with politically motivated local currency accounts.
How to best deal with inflation and foreign currency exposure
As inflation increases, the risks associated with dealing in foreign currencies will likely stay elevated; it is important that businesses plan ahead when managing their future exposures to various currencies.
One way of doing this is working with a trusted FX company so the business can plan and forward hedge their exposure when markets are liquid and stable.
Are you a business in need of a reliable international currency transfer solution? Sign up with CurrencyTransfer today to protect your currency exposure from FX market volatility.
Gustav Christopher is a writer specialising in finance, tech, and sustainability. Over 15 years, he worked in banking, trading and as a FinTech entrepreneur. In addition, he enjoys playing chess, running, and tennis.