Inflation sets a new frontier for digital financial services

The war in Ukraine has triggered worldwide inflation and, unsurprisingly, small businesses have been hit especially hard. We look at how inflation has increased operating costs especially for small manufacturers and food producers, compounding the lasting effects of the pandemic, especially supply chain issues. While digital financial services have the potential to offer ways of stabilizing cash flows, current offerings need to be updated to tackle inflation-induced volatility more directly.

Inflation is compounding economic problems

The war in Ukraine, with the loss of life and destruction it has caused, has been tragic for the country. It is now becoming evident that the war is also causing suffering and hardship across the globe, due to major economic ripple effects, especially a sharp rise in inflation. While Europe has experienced the most immediate and starkest hikes in prices (especially for energy), the rest of the world has not been spared.

It will take a few months for official statistics to emerge, but survey-based studies paint a clear picture: inflation is becoming one of the most — and maybe the most — pressing concern for small businesses. Of course, this doesn’t mean that previous stresses have stopped. Instead, inflation is compounding the detrimental effects of the pandemic, the global fragility of supply chains, and context-specific vulnerabilities of small businesses, from economic volatility in Nigeria to Brexit’s lasting effects in the UK. It seems that inflation could have hardly come at a worse time.

Rising cost and cash-strapped customers

Inflation can be particularly pernicious for small businesses compared to larger ones because it introduces volatility and insecurity. Small businesses often have less of a financial cushion, and they are more immediately affected by changes in their economic environment. For example, inflation reduces what small businesses’ customers are willing to pay, while these customers already have lower purchasing power than those of larger firms.

Yet, inflation’s most significant effect is a rise in costs for inputs, which results in higher operating cost. The current wave of inflation triggered by the war in Ukraine has led to price hikes especially for food staples and fuel. This has hurt ubiquitous types of small businesses, like food producers. Even in countries like Nigeria or Turkey, where inflation was high even before the current crisis, small businesses are now even more severely affected than others. Higher inflation for small businesses has also been observed in India, with small businesses indicating that rising prices for raw materials, fuel, and labor have posed the greatest problems.

Governments have been hard-pressed to find effective solutions. It is difficult to design cost-effective policies that direct financial help towards small businesses or reduce prices for key input factors, without distorting markets. Indonesia’s ban on palm oil exports has probably been the most drastic policy that has already taken effect. The Indonesian government also introduced various cash transfer schemes for individuals and small businesses, for instance, to subsidize the purchase of cooking oil. In India, Caps on prices for certain goods have been suggested in India as one short-term measure.

Can digital financial services soften the blow?

While such broad-based interventions may be necessary in the short-term, they risk being inefficient and unsustainable in the longer term. As inflation may remain an issue for several months and years, more targeted approaches that respond to small businesses’ real and specific cash flow problems are needed. This challenge could become a new frontier for digital financial services.

In particular, digital credit solutions are a natural fit to help small businesses steady their cash flows and, if necessary, access short-term loans to cover rising costs. Small businesses are already responding to inflation by extending their payment cycles — such strategies can be supported through financial management software such as for invoicing, bulk purchases, and accounting. As was the case during the pandemic, digital financial services can also facilitate targeted government support.

Odds are that inflation is here to stay. Existing digital financial service solutions urgently need to be adapted and customized to the specific price hikes and volatility that the most vulnerable small businesses are facing.