In the early hours of 24 June this year, the UK economy took a dramatic turn as the final referendum votes were counted and it became clear that the campaign to leave European Union (EU) had won.
Since then, the value of the pound has dropped by 10%. Sterling is now trading below $1.30 to the pound, the lowest for more than 30 years.
The Brexit referendum benchmarked a sea change in the UK economy – some factors directly as a result of the vote, others coincidental. But for businesses we’re seeing the end of a period of low background inflation and relative currency stability. The value of sterling has dropped and is more volatile, with inflation expected to increase – Bank of England governor Mark Carney recently said its set target of inflation at 2% could be exceeded in the next two years.
But is this good or bad news for civil engineering firms? Well, it depends on the nature of your business.
All businesses, whether they work overseas or not, or report their financial results in sterling or not, will be affected. For example, anything like an increase in the price of petrol will hit a firm’s bottom line. For those businesses that are heavily reliant on supply chains outside the UK, there is a direct cost that is quickly apparent and leads to extra construction cost and construction inflation.
The biggest hit will be for those businesses that are headquartered outside of the UK and run their accounts in dollars or euros. Any payments in sterling will yield fewer dollars or euros than they forecast. That’s not to say that these businesses haven’t mitigated for this outcome. Currency hedging is an effective way of blunting a hit.
Hedge your bets
“In advance of Brexit, smart companies would have been hedging their position ahead of movements in currency,” says Neil Broadhead, capital projects and infrastructure partner at financial services firm PWC.
But for those UK-headquartered businesses, reporting financial results in sterling and working overseas, it’s the opposite. If they conducted work outside the sterling zone and are now receiving those payments in dollars, that work will yield more sterling than anticipated. Likewise, exporters of materials will benefit if they’re agile enough to take quick advantage.
Where the value of sterling and its impact on civil engineering businesses gets more complicated is when firms start to think about how to run the business and bid for work over the next year.
For those businesses negatively impacted by sterling’s fall, the first area to examine is currency hedging.
Broadhead says that no one really knows whether the weak sterling is long term or not until there’s more clarity on the nature of Brexit: “I would be thinking about my hedging strategy and thinking about the extent I wanted to commit to long-term hedging strategy against shorter-term uncertainty.”
And while hedging may sound like a safe solution, it is also becoming more expensive. “Hedging foreign exchange risk is of course a sensible option to consider but it carries a cost of that some smaller firms may not have entered into before, and which some may feel ill-prepared to manage by themselves,” Association for Consultancy and Engineering economist Brian Nolk says. “Firms not yet familiar with forex risk management should consider taking steps but I would suggest they seek out advice from qualified experts.”
If work in the UK is going to pay out less once it’s exchanged into another currency, should civils firms headquartered overseas charge more to offset this? Will they even re-think how much UK work they bid for? Optimistically, the UK has a decent infrastructure shopping list, with major rail, roads and airports work in the pipeline and low interest rates.
Most firms will have to answer to someone, usually shareholders, for their financial decisions – and will have to tread a fine line between passing on costs via increased total contract prices and pricing themselves out of a job.
“It’s very unlikely that any reputable firms will be looking into their future business plans saying ‘yes, it is getting very turbulent but we’ll just muddle through as we used to’. They have to be seen to be doing something sensible and proactive about increased forex volatility,” says Nolk.
“My best advice for firms wanting to protect profit margins would be to optimise cost controls rather than just hoping forex gains will be advantageous going forward. In bidding for new work price adjustment isn’t the only way to manage currency fluctuations.”
“My best advice would be to optimise cost controls”
For those firms who may be currently benefitting from weak sterling, the question is how they price themselves on future overseas work. It may be that they look to take on more projects in dollars and euros as they’re may seem to be currently more attractive. The 10% drop in sterling may enough to help maintain a good margin even if the firms wanted to pass on a price decrease to the purchaser. But is using the current weak pound to differentiate your business on price and steal some market share the best way to use the money?
Use the advantage wisely
For PWC, this scenario is also an opportunity for firms to solidify their expertise and market footholds.
“It creates an opportunity to use that greater margin for research and innovation. It is important to see that opportunity and turn that into investment into an organisation in a way that maintains competitiveness,” explains Broadhead.
Of course, even this benefit comes with a caution. “Currency swings are never limited one way. No single significant movement stays there for long. Currency volatility works both ways so you would be unwise to take for granted the comparative advantage sterling currently offers some firms,” warns Nolk.
It’s widely acknowledged that the only certainty is uncertainty, but perhaps industry has to plan for even more uncertainty over the next year.