While currency risk comes with the territory of doing business in emerging markets, heightened volatility at this time is creating additional challenges. We ask several industry experts: what can treasurers do about it?
Various multinationals have bemoaned the bottom line impact of currency volatility since the start of this year. Diageo, for example, blamed it for a fall in revenues from Latin America and the Caribbean, while Volvo sought to minimise the impact of FX volatility by announcing plans to build a plant in the US.
On the other hand, Unilever’s first quarter results were boosted by favourable currency movements and Danone also came out ahead. But the experiences of Unilever and Danone are untypical according to the latest FiREapps currency impact report, which found that North American and European corporates reported a combined negative currency impact of almost $40bn last year.
Corporates on the other side of the Atlantic were most affected – North American companies reported $27.1bn in total negative currency impact for 2014, a 53% increase since 2013. And the impact wasn’t limited to a few big names either; in the final quarter of last year, 46% of North American and 51% of European companies had to report material currency-related impacts.
But what can treasurers do to minimise FX risk, especially in the emerging markets?
Andrew Gage, Global Head of Research at FiREapps, recommends that the approach to managing emerging market (EM) currency volatility should be the same as for developed markets. “Inter-company loans, hedging, option and natural hedges are all potential methods of countering risk – for companies with and without operations in emerging markets.” Therefore, he concludes, “the best strategy you can employ is having complete data.” He accepts that borrowing in local currency and managing working capital effectively can help reduce the impact of currency fluctuation, but also refers to the importance of having a full understanding of exposures and flows.
Meanwhile, Sander van Tol, Partner at treasury consultancy Zanders has a slightly different view: it has always been important for corporate treasury to manage their exposures on EM FX, but higher volatility and increased exposure has made it even more important, he observes. Compared to developed countries, he sees some material differences in the management of these specific risks, which can be categorised as: the regulatory environment; a lack of liquidity; limited hedging products and higher hedging costs.
“The regulatory environment is a key driver in EMs. The majority of EM currencies are restricted and not freely convertible, but because some are linked or pegged to another currency or basket of currencies, a proxy hedge could be a solution.” For instance, five out of the six currencies in the Gulf Cooperation Council (GCC) are pegged to the dollar, so a dollar hedge means a hedge in these five GCC currencies. Another example is the Chinese yuan, which is pegged to a basket of international currencies. The downside of such a proxy hedge is the uncertainty that a country can choose to unpeg its currency, which makes the hedge highly ineffective.
Rando Bruns, Group Treasurer at Merck, observes that high interest rates in many EM countries make hedging expensive and economically uninteresting. Corporates will have to live with that risk and apply a long-term view, he adds. “Local borrowing can be an instrument to reduce exposure, although the high interest rates need to be weighed against this exposure.”
Borrowing in local currencies is one of the traditional techniques used for FX exposure management. To the extent that timing differences between revenues and expenses can be managed, FX exposures can be managed at a lower cost and at a lower volatility to the financial statements explains Patrick Trozzo, Vice President for Reval. “However, many companies are also employing technology and more advanced strategies by automating the process of gathering FX exposures across multiple entities and efficiently netting them to optimise the execution of FX derivatives and reduce transaction fees.”
According to Ronald Leven, FX pre-trade Strategist at Thomson Reuters, the impact of currency fluctuations is largely a by-product of mismatched exposure profile for assets and liabilities. “Hence, local borrowing (when possible) can be a very effective tool for buffering a firm from currency fluctuations.”
Another technique for reducing the impact of EM currency movements, says Lauren Goodwin, an Associate Practice Leader Global Analytics at Frontier Strategy Group, is for corporates to consider country-specific factors since these can provide meaningful information as to where currency volatility may be most rampant. She suggests the questions corporates could ask include the following:
Where are central banks most likely to be controlled by political factors (rather than economic logic), thus, leaving them more susceptible to volatility?
Which countries have meaningful FX reserves that can be used to protect the currency in the event of a global macroeconomic shock?
Would multilateral or local banks be willing to lend to the government (buy bonds) in the event of trouble?
Is liquidity a serious risk?
In terms of what treasurers can do to manage EM volatility, she says clients should consider ‘operational’ hedging, which can buffer the treasury against large currency movements. “At the higher-risk end of the spectrum, corporates could complete a strategic acquisition to lessen the impact of currency on sourcing and production.”
The ability to move money out of certain countries is usually investigated carefully before a corporate invests in a country in the first place, explains Brian Welch, Director UserCare Treasury Consultancy. “Sometimes companies will invest in a particular country because of its economic potential, but if there are potential problems about paying dividends out of those countries the initial investment may be made with loans rather than equity, as the loans are sometimes more easily repaid. Similarly, finance from within those countries might be possible and preferable, so that any balance sheet exposure can be offset by local loans in the same currency.”
In the latter case, a counterparty risk will arise with a domestic bank or other financial institution. Although the local investment legislation might require the corporate to use a local bank – in which case the corporate will aim to use the best rated bank in that country. “There is less risk borrowing from a local bank than investing local cash with the same bank,” says Welch. “There is also the possibility of one of the global banks providing some kind of service.” Many EM countries maintain exchange control regulations to prevent the unlimited transfer of funds out of the country – but the existence of those regulations usually also means that there is an official route by which funds can be transferred out.
In general, the more volatile and free a currency is, the more flexibility corporates have to move money out of the country, says Bruns. “The best example of this is Venezuela, which has a highly regulated FX rate and restrictions on moving money out of the country. Counterparty risk goes along with this.” He also refers to the impact of political stability on a corporate’s ability to move cash as well as on FX rates.
The typical treasury team, according to Gage, often has a blindspot into its EM finances due to a pattern of opaqueness created by how businesses in emerging markets are acquired/integrated. “Legacy systems and processes often create areas that the team cannot see into, create a lag in the system or are not consistent with company-wide processes. These nuances often make it hard, if not impossible, to manage the risk associated with these markets.”
The extent to which the typical corporate treasury team has sufficient resources to effectively manage emerging market currency exposure depends on the size of the organisation, says Bruns. “Having said that, I believe it is good to be rather close to those currencies.” Improvements in the process of moving money in and out of EMs, according to Trozzo, have somewhat cushioned the impact of emerging market currency volatility on corporates. He goes on to explain that there are fewer cases of rigid currency conversion restrictions, which had been driven previously by frequent periods of hyper-inflation.
Factors such as banking infrastructure and political stability are taken into account when assessing risk in an EM, although Trozzo observes that such issues are of less concern than they were in the 1990s. Globalisation and investment in technology have upgraded banking infrastructures worldwide and many EM countries have established local financial markets that connect to global financial markets.
David Blair, an independent Treasury Consultant based in Singapore, observes that currency volatility is not limited to EMs, though the EM volatility has been exaggerated by dollar strengthening. According to Blair, EM currency volatility has yet to directly impact on exchange controls, while borrowing in local currency and managing working capital effectively can help reduce the impact of fluctuation. “Hedging is possible in most Asian EMs, both onshore and offshore via non-deliverable forwards and many treasurers are actively hedging. The typical multinational company will also have local currency receivable and hard currency payable for sales and the reverse for production.
“Funding local sales operations in local currency reduces risk, as does producing and selling in-country. Long day sales outstanding (DSO) in local currency add to risk; efficient working capital management, therefore, is vital.” Blair also warns that many corporate treasury teams lack the manpower to effectively manage EM currency exposure. “Most treasuries are under-resourced and multinationals that have centralised globally for cost reasons are left with no or limited EM expertise.”
According to Leven, recent earnings releases would suggest that the strong dollar has been a much bigger issue for corporates than volatility, causing potential credit problems for a lot of EM companies that are dollar-funded. Since most corporate exposure to EMs has a long time horizon, political stability is probably the number one issue, he continues. Banking infrastructure may also be a factor in determining whether to hedge on- or off-shore.
Market makers’ reduced appetite for risk, general uncertainty in the commodities market, increased regulation and continued uncertainty over Greece’s future as a member of the Eurozone have all contributed to volatility, explains Jon Dovener, Head of Emerging Markets, Lloyds Bank Commercial Banking. His colleague, James Buckle, Director of Industrials, says treasurers will usually try and use a well-established bank with a local presence and understanding, which can give them a real-time assessment of the local risks. “Alternatively, they may be inclined to use the local market’s leading bank. Any treasurer will value a local presence in a region deemed to have certain socio economic and political risks.”
Resources could be a factor – but approach and governance are more important according to Peter Wong, Associate Director, PwC Corporate Treasury Consulting in Hong Kong/China and Founding Chairman of the International Association of CFOs and Corporate Treasurers (IACCT) China. “A recent PwC corporate treasury survey found FX risk was the number one risk exposure, yet only 8% of treasurers adopted an active or dynamic approach that took into account business strategies and activities (including physical supply chain) with the goal of maximising market opportunities and profitability and cash flow.”
While accepting that borrowing in local currency and managing working capital effectively can reduce the impact of currency fluctuation, Buckle adds that certain larger corporates have a preference to fund centrally for a number of reasons (including cost), so may elect to utilise synthetic funding options such as a cross currency swap as opposed to borrowing locally.
“We see several differences in EM FX hedging strategies,” says van Tol. “The first is that exposure is managed from a portfolio perspective in which the imperfect correlations between the different currencies lower the exposure and hence hedging costs. Furthermore, corporates apply a shorter hedging duration in order to decrease costs of carry. Thirdly, more option structures are used to protect the corporate against specific event risks of a very material depreciation of the currency. The final difference is that macro-economic outlooks are used to determine a risk map or consensus on currencies to be used as guidance on hedge ratios.
“In order to reduce transaction risk, corporates can either change to invoicing in hard currencies or use FX adjustment clauses in their sales contracts. Whether this is possible depends very much on the market and sector you are operating in.” Van Tol believes that treasurers need to change their approach, strategy and hedging instruments: investing in specialised exposure quantification and dynamic hedging strategies pays off but normally, as he explains, that is only perceived as such after the occurrence of an event risk – the depreciation of the Russian ruble or the peso crisis, for instance.
Goodwin observes that any increase in global risk or major tightening by central banks (particularly by the US Federal Reserve, likely in Q4 2015) will lead to a reduction in EM flows and amplified currency volatility. “Currency volatility itself doesn’t make counterparty or credit risk more likely, but the causes of currency volatility do. The impending US interest rate hike is increasing volatility and makes countries with high proportions of corporate and sovereign dollar-denominated debt (much of Latin America, Angola, Kazakhstan) vulnerable to currency volatility while increasing the likelihood of capital controls.”
Welch acknowledges that the decision to expand operations into a new EM will come from the sales or manufacturing parts of a company and such momentum is often difficult to stop with treasury concerns about banking infrastructure or political stability. Companies with EM operations are likely to be supported by a reasonably sized treasury team, but EMs are often challenging, he concludes.
“External advice from the local offices of the major accounting firms is usually essential, together with advice from the global or local banks. There will also be a need for local financial staff and expertise, although they may not be officially part of treasury.
“The local banking facilities may be quite different from European banking, possibly with a higher usage of cash and cheques and less secure methods of collection and delivery. Practical local treasury management issues are possibly more time consuming than EM currency exposure management,” he concludes.