Treasury Today Country Profiles in association with Citi

Currency market volatility

This issue’s question

“We have recently witnessed negotiations between Unilever and Tesco on price increases as a result of the fall in the value of the pound following the UK’s Brexit decision. How are companies being impacted by the currency market volatility and what steps are treasurers taking to mitigate the risks?”

Portrait of Wolfgang Koester
Wolfgang Koester, CEO, FiREapps:

The aftermath of Brexit, perhaps more than any recent shock in a G10 currency, clearly highlighted there are still two camps of corporate treasury organisations – those who are empowered to be proactive about corporate currency management, and those who are still left on reactive footing.

Leading into Brexit, the proactive teams ran scenario analyses and projected the potential effects of a sharp GBP devaluation (or the versa); and further potential ripple effects. As the odds flipped, many teams ‘tightened’ (raised) hedge coverage for exposures such as GBP, USD and EUR. In the days before, these teams double-checked analyses, ensuring scenarios were still intact and as projected. Each time, the ‘current state’ and ongoing expectations were communicated to executives, and the cycle repeated a few days later and a couple of weeks later.

For these global teams, shocks and fluctuations happen – this is business as usual. But, thanks to proactive steps, financial results were insulated – no reaction required.

Contrast the proactive team’s actions with the reactive group. These teams scrambled for weeks, not only to accurately report the present impact, but also the future, expected impact.

So, in context, what steps have corporates been taking since to mitigate further risks?

Short term: companies in the proactive boat ‘stayed the course’. There have been further shocks which resulted in slight surprises (early October GBP) but for the most part it is business as usual.

Of the corporates caught in reactive mode, many used this opportunity to build internal support to empower proactive currency management. These corporates have been:

  1. Clearly documenting and communicating (internally) the existing currency process.

  2. Actively working to identify holes in process or programmes that result in poor timing or inaccurate analysis.

  3. Leveraging strategic partners such as banks, who have a plethora of value-adding services to offer, to empower their teams to manage this new, volatile environment.

Long term, both sets of organisations (proactive or not) are now going through yearly planning cycles in which an eye is focused on understanding the volatile markets and securing operational results, globally. This cycle is where pricing adjustments (and other tactics) come into focus. That said, while pricing adjustments and sales freezes are not new (Apple, 2014 Russian ruble crisis) they are often a last resort; taking other internal measures is often preferred and more cost effective/competitive.

Teams who were not prepared for Brexit but now have internal support, are taking a long-term view, putting into place programmes which prevent further internal shocks. Those who were proactive are staying the course. Both are/may still be reviewing pricing changes. In truth, the only bad (apparently dangerous) strategy after the latest shock is doing nothing. We’ve already witnessed, privately, the demotion of practitioners as CFOs were surprised that currency risk was not managed; and publicly, we have already seen a UK-based CFO (Sports Direct) step down amid continued currency impact and fallout.

Portrait of Philippe Gelis
Philippe Gelis, CEO, Kantox:

The Marmitegate illustrates the consequences of sharp currency fluctuations and the effect that they might have on the profit margins of importing companies like Unilever.

A sharp currency movement can have an immediate impact on the costs of an importer, and the pound sell-off after the Brexit Referendum – which has devalued approximately 20% against both the euro and the dollar – has put Tesco and Unilever in an awkward situation. Who is to blame for the price hikes?

The answer would have to be found on the terms of the agreement between the supplier and the retailer. In that sense, we might be in one of these three scenarios:

  1. The contract includes a clause that contemplates currency risks. The supplier has the right to change prices in case the exchange rate fluctuations exceed a certain margin. It might be that these margins are wide and that Tesco did not anticipate that the pound could drop to a 30-year low, as it happened. However, if this is the case, Tesco would be assuming the currency risk, even if indirectly, as Unilever is entitled to pass their higher costs in foreign currency to the product. It is on Tesco to choose between reducing their own margins and hold prices steady or maintain their margins and increase product prices, and face losing customers to competitors with cheaper options.

  2. The contract establishes a fixed price during a specific period of time. These contracts only contemplate a renegotiation when that period (six months, one year, 18 months) expires. The supplier takes the currency risk in the interim. In this case, Unilever would be responsible for establishing a currency policy that guarantees steady profit margins for the total volume of sales during the period of the contract. If such is the case, Unilever would not be entitled to change the prices of its products.

  3. The contract does not consider currency risk and the supplier wants to renegotiate prices because his costs have increased. It is unlikely that Unilever did not have any clause to cover its risk against pound devaluation (either regarding margins as in the first case, or in terms of time, as in the second case). In such a scenario both parties would have to negotiate who assumes the impact.

Currency fluctuations multiply impacts on corporate profits, as margins are eroded by several times the size of the movement. To explain, if your profit margin is 30%, a 15% decline on the currency exchange would not translate in a 15% drop on your profits, but would slash 50% of your earnings.

Portrait of Gary Williams
Gary Williams, Deputy CFO and General Treasury Manager, Mitsubishi Corporation Europe:

The Brexit decision certainly came as a surprise to many organisations and in line with well-publicised predictions the pound has suffered a wide-scale depreciation against other currencies. This volatility has impacted companies in different ways. A lot depends on the size of the organisation, its home market and in what currencies it transacts. For instance in sterling terms, an exporter pricing in foreign currency would have become more competitive of late. An importer, however might be finding these times a little more challenging.

That being said, the impact of Brexit on the currency market has put FX risk and the management of this clearly into focus for most companies. The need for an effective and robust FX policy is clear. Those companies, who have typically not managed FX risk proactively, may have experienced an unexpected FX gain or loss situation and therefore should consider the merits of having a policy in place. Whilst, on the other hand, those treasury departments that do have a legacy policy should be checking that this remains viable in these times of material changes to exchange rates.

No matter how this policy is drafted, however, treasury departments must always remember that its main objective is to manage the risk; not play the market. As such, any treasury policy should be able to hold firm, no matter what events occur in the market, by making it more robust to turbulence and clearly understood by all, including the board.

Elsewhere, treasurers in those companies impacted by the currency volatility have a chance to highlight the function’s strategic worth. Educating the key stakeholders within the business is a treasurer’s responsibility so that this often overlooked risk is clearly understood along with methods of mitigating it.

Long term, there are some fundamental and long-standing challenges that must be overcome for treasury departments to effectively manage FX risk. Key to this is ensuring that the information flow including forecasting is as accurate as possible. This will allow treasury to have a better understanding of what to hedge and what not to hedge and how to separate transaction from translation risk.

Key areas to consider:

  • The objective of treasury is not to play the market but to manage risk.

  • The result of the Brexit vote may have taken organisations by surprise, so when it comes to the impact of FX there will be winners and losers.

  • For companies actively engaged in business that is not in their domestic currency, it is crucial to have an understanding of the risks involved and have a clear FX policy in place, even if the policy states that there will be no FX hedging.

  • Treasury must not be dogmatic and therefore be open to revisiting the policy in light of the major shifts in FX rates that have been experienced.

Next question

“We keep hearing about big data and how it can be used to drive smarter decision making. What practical steps then can a treasury department take to begin to leverage big data?”

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