Changes in the economic environment is a challenge for companies. It could bring uncertainty to their operations. Predicting trends and their effects on businesses is a difficult task because its change is uncertain and beyond their control.
Shocks such as the 2008 and 2009 global recessions have had severe consequences for businesses. The crisis raised many problems for companies around the world, such as tightening access to financial resources and decreasing consumer demand. Commodity companies were also hit because of slow global economic recovery.
Definition of the economic environment
The economic environment is the nature and direction of the economy in which the company operates. The context is not only local or national but also regional and global.
You can see, globalization has increased economic linkages from one country to another. Internet, international trade, and investment are as a link between the domestic economy and the global economy. Shocks in one country quickly spread to other countries. Therefore, when you analyze the economic environment, you should consider what is happening in the world.
Indeed, not all variables of the global economic environment are relevant for all companies. So you have to sort and scan which ones are significant and then monitor and predict their direction.
Examples of economic environment and why they are important
The economic environment affects the business either directly or indirectly. Some of the economic factors have a direct impact on funding costs, production costs, and sales. While others affect indirectly, mainly through its effects on consumers (which then has an impact on company sales).
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I mean, the economic structure is the composition of gross domestic product. You can observe it from the expenditure side or from the output side. On the expenditure side, it consists of household consumption, business investment, government spending, exports, and imports. On the output side, it comprises various economic sectors, ranging from the primary to the quaternary sectors.
Economic structure affects economic performance. For example, high dependence on the primary sector will make the performance of a country vulnerable to global economic performance. Because domestic manufacturing is underdeveloped, if the global economy slows, economic performance will also be hit. That, in turn, affects other domestic economic variables such as economic growth, unemployment, and consumption.
Indonesia, for example, is very dependent on palm oil commodity exports. Many residents prospered when the price of palm oil was high in 2011. As a result, they asked for automotive products. But, when global oil prices fall, their incomes are hit, and demand for automotive products also falls.
You can observe it from the percentage change in real GDP. Positive economic growth (expansion) brings prosperity. The demand for goods and services grows steadily. At the same time, businesses also invest capital to increase production capacity. They also recruit more workers, causing the unemployment rate down. Households see positive prospects for their income and employment, encouraging them to demand more on goods and services. In short, the economic expansion brings golden opportunities for the sales and profitability of companies.
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In contrast, during a recession, pressures on business performance increase. Demand for goods and services fell, causing more intense competition. As a result, companies face sales and profitability pressures.
It is an increase in the general price of goods and services in the economy. Inflation affects business through various aspects. It affects the purchasing power and spending patterns of consumers. On the production side, it also affects wages. Companies often adjust wages by counting inflation.
High inflation erodes consumer purchasing power. Money becomes more worthless. Furthermore, when inflation is unstable, it can distort business decisions. Some business decisions require predicting inflation rates, such as raising wages and setting product prices. So, when it is unstable, it reduces the accuracy of its predictability, making it difficult for companies to make accurate decisions.
Interest rates influence the borrowing cost and therefore affect business cash flow. Some businesses have high levels of debt, and rising interest rates could cause them to fail to repay the loan.
High-interest rates also burden consumers. They will tend to delay the purchase of goods financed through loans such as mortgage and car.
Too, interest rates also affect investment allocation by businesses. For example, when interest rates rise, they dislike bonds because their prices will go down.
For companies, taxes are a burden. The increase reduces their net profit.
On the other hand, higher taxes also reduce household disposable income. That means, when taxes rise, demand for goods and services will weaken. They have less money to spend.
Some businesses benefit from increased government spending. Take the example of a construction company. They’ll be excited when the government allocates more funds for infrastructure development.
Government spending can also affect indirectly. For example, welfare programs such as unemployment benefits support the purchasing power of unemployed workers. That way, the program helps maintain their demand for goods and services.
Some businesses sell their products abroad. And the price competitiveness of their products also depends on exchange rate trends. Depreciation makes the price of their products cheaper for foreigners, increasing demand. In contrast, appreciation makes the price of their products more expensive in the international market.
But, the opposite effect applies to domestic importers of raw materials and capital goods. Depreciation makes imported goods more expensive, increasing production costs. Conversely, appreciation makes imported goods cheaper, reducing production costs.
Exchange rates also expose businesses through hedging costs. Volatile exchange rates increase the cost of hedging.
Capital market conditions
Indicators such as the stock price index and bond index are essential for businesses. Companies depend on the capital market to raise funds. They issue bonds or shares when they need capital to, for example, expand production capacity. The conducive capital market conditions certainly allow them to reap optimal funds.
Also, some companies, such as insurance, depend on capital market performance for their investment allocation. If capital market performance is excellent, they get a favorable investment return.
Furthermore, the capital market is also essential for households to accumulate wealth. Their investment is not only in time deposits or gold but also in capital market instruments such as stocks, bonds, and mutual funds. And wealth is one determinant of the demand for goods and services. I mean, if households have reached the wealth accumulation target, they will likely allocate any additional income to the consumption of products and services.
High unemployment rates indicate weak prospects for household income. More and more people are losing income. In this situation, the demand for goods and services is also sluggish. They will save more than increase consumption of products and services
Consumer confidence level
Households are optimistic when their income and employment prospects are positive, as during economic expansion. This optimism has a positive impact on the demand for goods and services. So, if they are optimistic, sales of products and services are also prospective.
Companies rely on bank loans for capital. And, consumers rely on loans to buy expensive items such as cars. When faced with high bad loans, banks will be more cautious in lending, despite the market interest rates began to fall. Therefore, it is more difficult for businesses and consumers to get new loan agreements.