Treasurers experiencing their first taste of high inflation can take solace from the fact that basic treasury management principles apply even in the most testing circumstances.
Former US president Ronald Reagan may have been exaggerating somewhat when he described inflation as being ‘as violent as a mugger, as frightening as an armed robber and as deadly as a hit man’, but there is no denying that its rapid rise over the last 12 months has been a worrying trend for many.
In January, UK price rises reached their highest level since just before sterling fell out of the European exchange rate mechanism in 1992, and eurozone inflation has never been higher. On the other side of the Atlantic you would have to go back to 1982 find the last time consumer prices showed a similar annual increase.
Some of the factors behind these increases will be familiar to seasoned inflation-watchers – the 1970s was a decade of energy crises, for example, while price rises are a common consequence of economic recovery as demand picks up. The difference this time, of course, is that the world is still grappling with the fall-out from an unprecedented pandemic.
However, there are still many steps corporates can take to mitigate the impact of inflation on their business, according to Richard Blokland, corporate treasurer at NewCold Advanced Cold Logistics in the Netherlands.
“These include provisions in customers’ contracts to ‘call’ price increases during a contract year when inflation for a relevant cost driver hits a certain level,” he explains. “Furthermore, businesses could differentiate the purchase of relevant cost drivers in terms of suppliers and/or contract tenors.”
With around two-thirds of its costs relating to personnel expenses, SAP has increased its investment in talent retention while to protect its product margins the company has inflation adjustments defined in its support and cloud contracts.
Treasury teams should include inflation scenarios in forecasts for funding and risk management and consider lengthening procurement and maybe duration of debt, suggests David Blair, Managing Director of Acarate Consulting.
“Other strategies for mitigating the impact of inflation include segmenting cash on hand into operating versus investment and exploring offsetting bank fees with earnings credit,” says Henrik Lang, head of global liquidity in global transaction services at Bank of America.
Corporates looking to quantify the inflation exposure of their business and the respective risks must first understand the type of inflation exposure the business is facing, whether there is enough pricing power to pass on potential price increases, and how earnings are developing compared to costs, adds Ole Matthiessen, Global Head of Cash Management at Deutsche Bank.
Simon Geal, Executive Vice President of procurement and supply chain consultancy Proxima identifies three possible approaches:
Collaborating internally to identify where impact can be mitigated through simplification, substitution, cost engineering, or price uplifts.
Working differently with suppliers and where appropriate creating partnerships, instilling innovation and ultimately securing supply which could also come from opening new sources.
Cutting out overspend in terms of pricing or volume.
Dino Nicolaides, Head of Treasury advisory UK & Ireland at Redbridge, recommends that corporates assess the effectiveness of their hedging policies in the context of higher inflation and potentially higher interest rates.
“From a cash risk management perspective treasurers also need to identify any cash that is trapped across their organisation so that they can utilise it effectively,” he says. “In a low interest rate environment where corporates can borrow relatively cheaply this might not be a priority, but if central banks raise interest rates sharply to combat inflation the cost of this idle cash will increase.”
Options for corporates that find themselves in this position include implementing automatic cash pooling arrangements and reviewing intra-group lending processes.
Ghulam Alahi is practice principal at professional services firm Vision Consulting and managing director of firms in the real estate and retail communications sectors. He says treasury teams also need to take account of competitors’ responses to rising inflation and determine whether price inflation experienced by the business is a supply issue that could reverse when supply chain pressures ease.
With a number of central banks either already raising interest rates to bring down inflation or likely to do so in the coming months, Alahi says some corporates could be faced with the double whammy of immediate and ongoing cost increases at the same time as the pressure of interest rate rises on their business and customer base.
“This may create opportunities for companies with surplus cash,” he says. “However, for a company that funds its working capital through borrowings there will be various aspects to consider such as where it is in the borrowing cycle in terms of the review point, whether the existing borrowing is on fixed or variable terms, and whether the borrowing is subject to any covenants that may be breached.”
Nicolaides acknowledges that there is no easy answer to the question of whether higher interest rates are more or less of a concern than high inflation.
“High inflation erodes consumer purchasing power, which can lead to a slowdown in the wider economy that tends to affect companies operating in non-essential goods and services such as the luxury goods market disproportionately,” he says. “High inflation also increases the price of raw materials. When inflation rises, the value of cash is eroded and corporates may need more cash for their day-to-day operations so corporates need to review the extent to which their pricing strategy can compensate for this.”
On the other hand, higher interest rates as a mechanism for maintaining inflation at an acceptable level (2% in the case of the Bank of England), can impact investment decisions as debt becomes more expensive, increasing the required return on investments.
“Higher interest rates are more of an issue as they will have an impact on bank covenants,” agrees Blokland. “But if a business has put in place an interest rate hedging programme which was tested and found to be sustainable, it probably won’t be an issue.”
SAP makes the point that we are still in a historically low interest rate environment and that negative interest rates on investments in the eurozone have a significant negative impact of business despite the financing benefits.
Lang observes that in either scenario – higher interest rates or high inflation – the net economic benefit or cost to companies depends on what balance sheet positions and business models they have employed.
“For instance, companies that have more short-term liquidity compared to floating rate liabilities may benefit from higher rates,” he says. “Consider how some companies locked in longer-term funding (for example, bonds) when rates were low – they stand to benefit from higher rates. In a high inflationary environment, companies with more pricing power will likely benefit since they are able to pass through to their consumers the higher charges they receive from their suppliers.”
It is also important to note that the toolset for mitigating interest rate risk is far more advanced than that for inflation. “Highly liquid swap markets, financing structures and other solutions should allow treasuries to fully manage interest rate risk,” suggests Matthiessen. “As inflation risk sometimes cannot be mitigated, it could make sense to increase the focus on risks which can be hedged more easily.”
As for the extent to which businesses have been affected by greenflation or inflation resulting from the transition to a green economy, Nicolaides observes that the corporates he speaks to generally view this as a short-term phenomenon that will have a long-term positive impact on their business.
“The transition to a more sustainable business model can require significant investment for companies in the short term,” observes Lang. “However, over the past few years it has become clear that investors and lenders value companies that prioritise ESG metrics (a phenomenon referred to as a ‘greenium’).”
This chimes with the view expressed by NatWest in recent a report on the post-pandemic economy, in which it states that while the transition towards a greener economy poses macro uncertainties and short-term inflationary pressures, the effects decrease significantly over the longer-term as a result of cheaper technologies.
Corporates which are proactively tackling these challenges have benefited from higher demand for their products or higher investor attraction, while those in need of green solutions have had to pay higher prices for goods and accept longer waiting times according to Matthiessen.
“In the light of high carbon prices, implementing innovative and clean technology becomes more important,” he adds. “Assuming carbon prices stay elevated, companies that rely on conventional technology for the future will face significant impact on their business model. The increase in prices has impacted all businesses and the recent increase cannot be solely attributed to the transformation to a green economy.”
It is also important to note that inflation and greenflation are not the same thing. It is possible for some companies to experience inflation as a ‘here today, gone tomorrow’ situation if the industry in which they operate is resilient and the supply chain re-establishes itself relatively quickly and smoothly. In contrast, the effect of transitioning to a green economy is continual costs.
“Uncontrollable political factors will affect the move towards a greener economy and determine whether the ‘green train’ accelerates, decelerates or simply stalls for a while,” suggests Alahi. “For the treasury professional, the costs of going green are likely to be ongoing and for public companies in particular there is greater attention being given to the green or not-so-green effects of the company’s operations with the need to comment and report these aspects.”
SAP accepts that the shift towards renewable energies as well as increasing CO2 prices and special taxes on fossil energies might lead to higher energy price levels on a mid- to long-term basis. However, it says it is working on various initiatives to increase energy efficiency as well as reduce CO2 emissions in its operations, such as carbon neutrality in its own operations by 2023 and a commitment to achieve net-zero along its value chain in line with a 1.5°c future in 2030.
“We are affected as energy is one of our most relevant cost drivers so we are acting on this development actively,” says Blokland. “Our business needs to make this transition in the end and there are a lot of opportunities to do so.”
The effects of change are being felt across many other aspects of the corporate world, adds Geal. “What we are seeing is a convergence of business strategies when it comes to procurement and supply chain,” he says. “This means that a lot of businesses are looking to do many of the same things at the same time, such as greenification, automation and digitisation.”
This is creating inflation in supply markets not just for products and services, but also for the strategy, transformation and change services that are needed to knit it all together. “Specifically in greenification we are seeing product and skills bottlenecks appearing which are pushing back lead times and pushing up prices,” he concludes.